Sunday, October 25, 2009

Are the Bankers Pay Cuts Regulatory Short Cuts?

The Federal Reserve announced last week that it will scrutinize pay practices at banks of all sizes for excessive risk taking, especially in the short term. Large banks will receive special attention, but banks of all sizes will be reviewed one way or another. The Fed said banks should compensate for longer term performance and avoid undue risk to themselves or the financial system. In particular, the Fed indicated that incentive compensation arrangements should be adjusted for risk--e.g., a high risk activity might pay a lower percentage of profits as bonuses than a lower risk activity, so that bank executives and traders won't be drawn to betting the ranch at the expense of the taxpayers.

Not even Rip van Winkle would be surprised that bankers are whining. Some predict that the most talented employees will jump to less regulated firms, where they can maintain the high levels of compensation they've been earning. Employees engaged in high risk activity might be particularly motivated to find a less regulated employer. Banks losing key employees may step back from some of the dicier activities that have generated significant profits in recent years. Bank profits might moderate as the banks tone down their risk levels.

This could be exactly what the regulators want. Formal regulatory reform has bogged down in the usual lobbying scrum where efforts to make law that protects the public interest all too often results in law that protects powerful business interests. The beauty of reform through the regulation of incentive compensation is that the banking agencies can implement it using their existing legal power to ensure the safety and soundness of banks, faster than the legislative process, and with greater certainty of getting the reforms they want.

Congress has complained about the free hand the Fed has had in supporting, subsidizing and bailing out the banking system, with, in the eyes of some legislators, little accountability. Congress now has a chance to make its contribution through the enactment of meaningful reform. We're still waiting for results. In the meantime, the Fed doesn't seem to be waiting for Congress. And a good thing, too, since risks continue to abound in the financial markets and there are plenty of ways for banks to lose money. Taxpayers shouldn't provide subsidized opportunities for big banks to act like hedge funds. If some of the wilder and crazier employees leave the big banks, and the latter consequently have to step back from dicier activities and shrink their balance sheets, becoming the dull depository institutions of the Ozzie and Harriet era, the outcome would probably let taxpayers and depositors breath more easily.

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