The Fed's Errant Crusade To Reform Bank Pay

Bernanke Serious

The Obama administration’s Treasury Department and the Federal Reserve are preparing new rules that they argue will reduce the risk to the financial health of banks that bonuses linked to performance can create. These efforts, however, are largely misdirected: our crisis was not brought about bankers recklessly seeking risk but because bankers mistakenly believed risky investments were safe.

Good policy rarely arises from factual error. But if we were simply placing restrictions on Wall Street pay without proper justification, the errant policy would be perhaps unjust but not dangerous. Unfortunately, in this case the policy misdirection should be a cause for alarm.  If the government adopts a policy that it thinks will reduce risk to the financial health of banks but is actually ineffective, we might generate a renewed false confidence in the health of our financial system. Once again, investors, regulators and bankers themselves may fail to perceive mounting instability.

The Fed and Treasury are planning to present guideline to reduce incentives for risk and also to conduct thorough going examinations that will apply not just to the pay and bonuses of top executives but also of traders, loan officers and others. At the biggest and most complex institutions, which the times says will include roughly 20 companies, bank regulators will be authorised to review and demand changes to compensation plans.

Some of the policies that the government will likely favour are:

  • bonus deferrals for several years, which would permit enough time for risks and potential losses to be uncovered;
  • linking the size of performance bonuses to the riskiness of particular businesses; and
  • “clawbacks” that would enable banks to reclaim money if profits turn out to have been illusory in light of later losses.

Where is the evidence that these policies would have prevented our crisis? There is next to nothing, as far as we can tell. Instead, we have a kind of unwarranted assumption that it was poor incentives rather than something else that led banks astray. It’s a just-so story of the banking crisis: once there was a bank that rewarded risk and didn’t penalise failure, so the bankers pursued risk so far that they ruined the bank.

The problem is that this just so story doesn’t really fit with the facts. In the first place, many banks already had policies that are very close to the ones the government wants to require. Bankers at Lehman Brothers were heavily invested in shares of Lehman Brothers, owning 25% of the shares. Most had stock options to purchase more, giving them the equivalent of a bonus deferral. When Lehman Brothers went bankrupt, many lost sizable chunks of their wealth, which had the effect of a clawback. 

More importantly, if bankers were blindly pursuing risk, they would have loaded up their balance sheets and trading books with the highest yielding, lowest rated securities. In fact, they did just the opposite. Just 19% of rated securities held by banks were AA or lower. By contrast, 81% of bankers chose to acquire AAA rated securities, the safest stuff around. This preference for safety indicates that bonus incentives were not making bankers heedless of risk.

What’s more, banks often bought insurance on the securities they purchased, seeking to water down whatever risk remained. This was a thriving business for the bond insurers and for companies like AIG that sold credit default swaps. If bankers were reckless gamblers, bond insurance would have been unpopular. The bankers mistakenly believed they were being prudent and careful despite a bonus system that seemed to incentivise them to be imprudent and reckless.

There’s a tendency to heap scorn on the actual words of bank executives assuring investors that their institutions were safe at the height of the crisis. Alan Schwartz at Bear Stearns and Dick Fuld at Lehman Brothers both argued that their investment banks were healthy just before they collapsed. Since misleading shareholders has serious legal consequences, it seems far more likely that they were simply mistaken rather than intentionally lying. Fuld reportedly turned down an offer of billions in new capital from a Korean financial institution just days before Lehman went bankrupt. Why would he do this unless he was mistaken about the health of Lehman?

This isn’t to deny that a bonus structure creates incentives for certain behaviour. And incentives can matter, changing the way various people behave. But the question isn’t whether theoretical incentives theoretically might cause bad behaviour. It’s whether real life bankers working at banks in the real world were knowledgeable about the risks of buying triple-A rated securities and chose to ignore those risks to earn bonuses. It’s an empirical question that needs to be answered with evidence. A just-so story won’t cut it. And so far there’s little evidence for the assumption the government is making and a good deal of evidence against it.

It’s ironic that the policy answer to a crisis that appears to have been caused by error and ignorance will itself likely be based on error and ignorance. But the irony becomes scary when we realise that the policy of compensation reform may encourage another error of confidence in the safety of the banking system. The bankers underestimated the risks of the securities they bought,  the regulators misunderstand what made bankers buy risky assets, and everyone may mistakenly assume the new regulations have made us safer. The consequence of errant acquisition of securities was a disaster. And the consequence of errant policy making may likewise end in crisis.

In an odd way, the assumption of the government is based on too much confidence in bankers. It assumes that bankers will automatically get what they want. If so, the problem is just to change what they want. Make them seek long term gains entailing less risk instead of short term risky bets. No doubt it is the fact that there are readily available solutions that attracts policy makers to the assumption that it was incentives. But the available evidence suggests that this confidence in banker performance is unwarranted. Bankers–like investors, regulators and ratings agencies–were mistaken and not very good at achieving their goals of safe gains.

Policy makers in government will likely resist the idea that it was mistakes rather than incentives that led to the crisis because this idea doesn’t readily lead to centralized policy correction. That is, here incentives matter: policy makers are motivated to adopt a view of the crisis that further empowers them. And so we expect that mistaken view of the crisis to continue to hold sway. Unfortunately, that means that many will believe we’re making the financial sector safer when we are doing no such thing.


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