Financial Regulation, a Slightly Optimistic View

The big news on the regulatory front last week was the Wall Street Journal’s revelation that the Federal Reserve will give its regulators the ability to reject any pay package for any bank employee that encourages excessive risk-taking. The Fed is apparently claiming this authority on the grounds that as a safety-and-soundness regulator, it has the right to prohibit any bank practices that threaten the safety and soundness of the bank. Sounds good to me.

Now, there are certainly reasons to be skeptical, which Yves Smith abundantly outlines. This could be a ploy to gain some populist credentials and head off more Congressional oversight of the Fed. The Fed has been willing to trust banks to tell it what their risks are, so it is not equipped to identify compensation packages that create excessive risk. TheFed will be looking (according to the WSJ) for outliers among the group of the top 25 banks – so as long as all 25 banks are engaged in the same silly compensation practice, the Fed will let it go.

Still, though, I am a little bit encouraged that this is on the table. Only a few months back, Treasury was trying to convince us that the best it could do on banker compensation was (1) say-on-pay legislation (non-binding shareholder up-or-down votes on executive pay packages) and (2) increased independence of compensation committees. As I wrote at the time, these proposals both suffer from the near-fatal flaw of relying on shareholder governance, which (a) is weak and (b) suffers from the same skewed incentives that managers do.

The idea of Fed civil servants vetoing traders’ pay packages just shows how tepid the Treasury proposal was. While I share much of Smith’s skepticism, I at least hope that this will move the ball in the right direction.

By James Kwak

14 thoughts on “Financial Regulation, a Slightly Optimistic View

  1. I do not share your “slightly optimistic” outlook.

    TBTF has gotten bigger; the failure of these firms is even riskier to our economy than it was a year ago.

    The banks operate on a daily basis knowing that fact. Whatever profits they earn on stupid and highly risky bets are their’s to keep.

    Whatever losses they incur on stupid and highly risky bets are the nation’s to absorb.

    What power will the feds exert over these institutions? Sadly, I have a really hard time seeing the feds vetoing anything done by the banks. I fear we’ll see more of the same unquestioning support for whatever scheme the banks develop – and when the next crash happens, the feds’ll hold out the TARP once again.

  2. Notice the INTENTIONAL vagueness of what is a pay package that encourages excessive risk-taking. Would it have anything to do with the fact that any attempt to SPECIFY, DEFINE, AND PUT IN WRITING what is a pay package that encourages excessive risk taking will immediately bring up multiple cries of “Foul!!!” and “Un-American!!!” from at least a dozen bank industry associations. Followed by a dozen+ Republican lawmakers previously bought and paid for crying “Foul!!!” and “Evil communists!!!”.

    If the Federal Reserve doesn’t have the guts to DEFINE IN WRITING (or at least give some examples of) what is a “pay package that encourages excessive risk-taking”, what are the chances they will actually ENFORCE it???

  3. You have totally misunderstood the purpose of this tool.

    The Government and the Feds are doing everything to prevent banks from returning funds back so that they can stay free and independent. Instead they are latching onto control so that they can continue forcing banks to continue promiscous lending and supporting the government, which they know is at some point going to run out of money and favourable lending terms.

    This tool will be used to pick on those banks that fail to play ball. Not the other way around.

    You should look at the tool, not it’s motivation of existance. The motivation is all lies, however what it can be used for is a reality!

  4. If what you’re saying is that this sort of raises the bar for what doing nothing means, that is cold comfort indeed. Yves Smith points out all the reasons this amounts to — well, nothing. And why this tough talk to avoid tough action may even be worse than nothing.

    As for the mechanics, I assume it would be the NY Fed doing most of this monitoring. And who composes a majority of the NY Fed board? The very banks who are going to be monitored here.

    Can you really imagine Tim Geithner, who seems to have spent most of his days as President of the NY Fed eating lunch and playing tennis with his paymasters, having done anything meaningful about pay?

  5. James Kwak writes “I at least hope that this will move the ball in the right direction”.

    And I hope that he will at least be able to take his eyes of this ball, since the compensation of the financial executive amounts to even less than the tip of the iceberg of our regulatory problems.

    What do you want? A pay package that encourages risk-adverseness? What banks do you think will result from that!

    Sorry, you find yourself on the wrong battleground!

  6. While I laud optimism, I see little reason for it in the proposal. As safety and soundness regulator, the Fed is primarily interested in re-establishing/maintaining the profitability of banks, particulary those TBTF. They are, to say the least, conflicted when faced with risks that may increase profits because profits increase soundness. The Fed has consistently favored profits over safety when it comes to the largest institutions. It does not have the talent to calculate risk, as James points out. Moreover, attempting to control risk through compensation control is too indirect to be effective. Remember, most of the losses came from the investment banking side of the businesses, not the blue-suit crowd, and no one is going to turn investment banking/trading compensation practices upside down.

    More significantly, this approach like most that have been put forth by the administration rely exclusively on the ability of regulators to want to regulate, identify the need for regulation, adopt the appropriate regulations and then have the conviction and ability to enforce the regulations. The last almost 30 years have taught us the folly of this approach. Moreover, even well-meaning regulators have a difficult – if not impossible – task of challenging a financial industry that is able to shower money on lawmakers and fill the halls of Congress with smooth-talking, money-spreading lobbyists whenever a regulation or legislative reform it doesn’t like is proposed. And if you think this state of events is a problem today, wait until the Supreme Court rules on the issue of the first amendment and corporate speech this term!

    The best way to reform the financial and financial-regulatory system is to restructure the industry including the elimination of those TBTF. Recognizing prudent limits on corporate political speech would also help, but it won’t happen under this Court. And that fact underscores my first point that we cannot rely on individuals to consistently recognize the needs of the general public and adopt policies and practices that advance those needs.

  7. I went back and read Yves Smith’s post a little more carefully (as I should have before). And it is interesting the timing of when that tougher language came out. The language still isn’t that strong, but seems more stern than what the Fed has come out with to now.

    The timing does imply political reasons/connection with Ron Paul’s “audit the Fed” bill as Yves calls it. Before, I thought I smelled a rat (Ron Paul’s intentions) in that bill. Everything I ever read in my college textbooks said getting the President or Congress sticking their schnoz into the Fed’s business was a bad idea. But if the threat of an audit hanging over the Fed will make them stricter about the amount of derivatives banks trade and stricter about definitions of what these banks label “capital” on their balance sheets, that would be a great step in the right direction.

    IF that was the case (a big IF), Ron Paul would become my new hero.

  8. The culture of pay for performance, with performance measured by immediate gratification (production) completely permeates both retail and commercial banking. What happened in the Investment banks is replicated throughout the institutions with the use of extrinsic motivational tools to “create value”. This has already been proven to be ineffective in the long run, but bank managers can’t say that because the culture from the top has sold out and they cannot abide people with different values. Anyone who dissents must be marginalized to protect the payoff. The philosophy must be different, the society must be different, the culture must be different. So for Obama to attempt to work from within the system is doomed to failure. Only setting up a system in competition with the current system will create conditions where the marketplace of ideas is re-opened and the market can drive change.

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