Last week the Fed revealed that it would begin to review the structure of compensation at large, important financial institutions to assess whether they were encouraging too much risk taking. This stunning powergrab–no elected official has ever voted to give the Fed this power–is a terrible idea.
As UCLA Law Professor Stephen Bainbridge points out, government regulators at the Federal Reserve are not well positioned to determine how to set compensation policy to encourage just the right amount of risk. This isn’t something that can be determined a priori. It’s hard even to imagine what kind of evidence would count for or against whether the correct amount of risk was being taken on. The question is just too abstract.
The normal way of deciding such things is through the market. We allow shareholders–whose diversification typically results in the demand for more risk–to contend with management–which is uniquely exposed to concentrated risk at a bank and typically wants lower risk. In addition, creditors with fixed returns usually want risk reduced since they don’t see the upside from increased risk. Finally, competition from other firms both in the capital markets and in trading puts at check on each of the three other forces. This four way tug-of-war never arrives at the “correct” answer but instead results in on ongoing market process that is the best approximation we have to reaching an answer.
Bank regulators cannot accurately mimic this process and there is little reason to expect them to do a better job. For one thing, government regulators have a very bad track record of allowing too much risk at the most closely watch firms: Fannie Mae and Freddie Mac.
Of course, in light of the recent debacle, this time regualtors are most likely to err on the side of being overly conservative. But since this new conservatism will likely diminish short-term gains for the financial secotr, it will encourage capital and labour to flow to other industries.
Here’s how Bainbridge describes the problem:
Financial institutions owned by shareholders thus must take into account the basic fact that shareholders have a strong incentive to favour risky projects. Because creditors have a prior claim on the firm’s assets and earnings, they get paid first; shareholders get the residual—whatever is left over. Shareholders thus prefer projects offering potentially high rate of returns, so there will be something left over after the creditors get paid.
If compensation policy encourages banks to reduce the risks they take, that policy will inevitably result in a lower rate of return for shareholders. This will significantly distort the flow of capital. Shareholders will divest bank stocks and invest in industries offering a higher rate of return. This will raise the cost of capital for banks and perhaps have the unintended consequence of making banks weaker rather than safer.
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