Here’s what we know so far about the plans for the US banking system that Tim Geithner will unveil next week.
- The heart of the scheme will, most likely, be an insurance arrangement, in which the government (part Treasury and mostly Fed) insures a big part of large banks’ portfolio of toxic assets against further loss. The devil is in the pricing of this insurance and how transparent that is – and we will put out more on this shortly – but the clear signal so far is that this will be a veiled major recapitalization of banks at taxpayer expense.
- As announced yesterday, the government will set restrictions on the pay of executives in banks that participate. But note that, under these rules, bonuses are not restricted. Instead, they are just deferred and paid in shares. In other words, if there is cheap recapitalization through government-provided insurance, these executives are getting an incredibly good deal.
Think about it this way. While the macroeconomy goes badly, the government will pay out on the insurance policy and keep the large banks in business. Once the macroeconomy turns around, as of course it will, the banks can pay off the government and pay out massive bonuses.
We are, in effect, insuring incompetents (i.e., the executives who got us into this mess) against both the delayed consequences of previous bungling by themselves and any future missteps they may make.
But even this won’t be enough for the top dogs on Wall Street. We predict that banks will start resetting the strike price of previously deferred bonuses, along the lines of what we have already seen from Google. Watch carefully and track what happens in your comments here.
What we really need is a simple, transparent recapitalization of the banking system. More complicated proposals are opaque and less likely to work. And once people see through the illusions, there will be great disappointment and much resentment.
(This post was written jointly by Peter Boone and Simon Johnson)
The Baseline Scenario 
I have a question. The Obama administration is being advised by some of the top economists in the world… yet this is their best idea? How could that be?
In a cash-strapped situation, it seems to me most prudent compensation committees would choose to compensate executives with stocks and options, rather than cash anyway. And, to make sure the executive doesn’t jump ship before the company is righted, the prudent Board would choose to vest the options over time—thus aligning the interests of the executive with the interests of shareholders. As preferred shareholders of the newly-semi-nationalized banks, the government has every reason (and every right) to want to align executives interests with their own.
Plus, the government has another motive: by limiting the amount of cash that leaves the company as executive pay, the administration is leaving more cash on the books of the firm—which is the entire point of the TARP program: getting more liquid assets on more balance sheets will thaw the credit markets.
So, unless I’m missing something, the administration edict amounts to good corporate governance codified; it aligns the interests of the executive with those of the company, the interests of the company with the interests of the global financial system, and—an added political bonus—it appeals to the common sensibilities of the blue-collar political base.
Is the cap on executive salaries politically symbolic or will it actually have an improvement on banks’ balance sheet. Without any empirical evidence, my inclination is to say that the salary cap will free up millions when the problem is in the magnitude of billions. Am I off base?
Insurance trumps simple recap because it is a future expenditure instead of a current one.
Americans (in the aggregate) will almost always opt for payments in an uncertain future over payments now, and income now over income in an uncertain future.
The insurance plan simply cannot be improved upon. What plan could better ensure that management “swings for the fences” on risk? Isn’t that what the Fed and Treasury want? A renaissance of risk taking, a return to the “damn the torpedoes” attitude that reigned during our golden era?
Please, if you goal is to increase leverage, then align management comp and the balance sheet structure with that goal. That is exactly what Summers and Geithner are doing. We will pay the price, for sure, down the road.
I can’t see Volcker staying around, nor quiet, if this is it.
greenmam: incentives are nicely aligned, mr. geithner is feeding his friends at the banks, and they will feed him later with an appointment similar to Robert Rubin, paying $120m over ten years in bonuses and, as mr rubin tells us, “I could have got much more”. I agree: only Volcker will quit.
Why not dictate that bonuses be paid in subprime CDO’s?
I think it will be quite interesting to see how this whole salary cap plays out. Part of me thinks there has to be at least some loop holes, mentioned and not, that will allow these execs to take home handsome salaries (like 500k isn’t a handsome salary already).
Also I want to see how the execs who the caps will impact react to the limitation. If integrity even exists anymore, it will say a lot about the company heads who stay on and stay proactive despite their salary reduction. It’s not like these guys don’t care about what they’re doing…
Vidal, Tomas Wiles–I concur this is primarily a political sidebar to the larger discussion. Truly: how many executives actually make more than $500k in salary? Probably only group presidents and above, so we’re talking about maybe a dozen or so people at any one company. Nevertheless, it seems an important element in restoring public confidence.
My question is similar to Nemo’s. Which economists agree with this methodology? I can see how bankers would agree with it. But does it “do the right thing” according to *any* of those who study the subject. If there are economists who agree, why do they think it’s a good idea?
nemo,
Remember that the bankers got their tax cheat in where the health lobby failed. That should answer your question.
Limiting exec salaries and bonuses is just one part of a plan. Expense accounts, benefits, lobbying, and all other aspects of compensation must be explicitly controlled. In a phrase, these dogs must be spayed and neutered.