The Fed has apparently gotten so frustrated with the Obama administration’s inability to bring change to Wall Street that it’s taking matters into its own hands–parachuting Fed regulators into the bowels of banks to make sure their compensation policies don’t encourage inappropriate risk-taking.
We’re all for more intelligent Wall Street compensation policies. But these should come from Wall Street, not Washington.
Back in the very old days, before everyone decided that letting Lehman fail was the biggest mistake made in the history of government, before Washington started to pretend that it could control everything that happened in the economy, there was a pretty good system for regulating Wall Street risk-taking:
Let stupid firms fail.
We need to get back to that.
Yes, the fact that the “stupid firms” this time around included most of Wall Street shows that special rules of financial bankruptcy should apply so the whole system doesn’t collapse. But the firms need to be allowed to fail.
What should the special rules of financial bankruptcy be?
- managements should be tossed
- compensation contracts and other liabilities should be torn up,
- bonus pools should be zeroed until the firms return to annual profitability
- equity and preferred holders should be wiped out, and
- junior bondholders should get a major haircut through the immediate, forced conversion of debt to equity.
All of this should happen not over years in the courts, but overnight–in the manner in which the FDIC seizes failing banks.
In such proceedings, all of Wall Street’s idiocy enablers will lose their shirts: The folks who work the at the firms, the folks who lend money to the firms, the folks who invest in the firms and trust the firms’ managements to be something other than morons.
Losing your shirt generally has a sobering effect on decision-making. As long as managers, lenders, and shareholders know they will lose their shirts, the next generation of Wall Street enablers will likely be far more careful and demanding than their predecessors, at least for a little while (and don’t hallucinate that the Fed’s new policy is anything other than temporary).
Instead of trying to stick a bureaucrat mini-pay czar in every bank to micromanage compensation, therefore, the Fed should simply develop a clear set of rules for what it will do to firms that fail (all of the above). Once the government sends a clear message that this is the fate that will befall any firm that gets itself into trouble, there will be a lot of sobering up on and around Wall Street. And that should have a quick and profound impact on compensation, without the Fed having to get involved.
Lloyd Blankfein and Pete Peterson, both of Wall Street, have recently floated some intelligent compensation practices designed to boost the long-term value and health of Wall Street firms:
- long-term versus short-term incentive plans (comp based on multiple-year performance)
- heavy emphasis on equity versus cash comp (screw up and you’ll go down with the ship)
- restrictions on sale of equity comp (execs have skin in the game)
- clawbacks (to discourage traders who have made a fortune in prior years to bet the firm in the next one)
These are all good ideas. They will help build sounder, stronger, smarter firms. If the policies are transparent and rigorous, they should also lead to higher stock prices, as investors recognise which firms have smart incentive plans and which are being reckless and dumb.
Meanwhile–and here’s the real role for government on Wall Street–the Fed and Treasury should also drastically limit the amount of leverage Wall Street firms and banks are allowed to take on.
In the years leading up to the collapse, 30X-40X levered bets became the norm. As any weekend gambler can appreciate, it’s not hard to go bust when you can borrow $30-$40 on margin for every dollar you have–and it’s easy to borrow that $30-$40 when the folks lending it to you know that the government will guarantee them against any losses. 10X-15X leverage limits seem more reasonable, and lenders should actually be putting real money on the line (And this, too, of course, will have a dampening affect on compensation).
Also, firms should be required to disclose every conceivable liability and factor it into their leverage calculation, including derivatives exposure. There shouldn’t be any “off-balance sheet” assets or special-purpose vehicles, at least not any that could have a material impact on the firm’s capital ratios.
In short, Washington’s Wall Street “fix” should be two-fold:
- Encourage Wall Street to reform its own compensation policies and behaviour by making clear what will happen to firms that get in trouble, and
- Reduce the likelihood of disaster by setting simple, clear leverage limits.
If we do that and firms still blow themselves up, then so be it. The financial system will be insulated, and Wall Street’s lenders, shareholders, employees, and managements will have only themselves to blame.