The Fed’s phony war on bonuses

September 18, 2009

Any attack on bank bonuses is going to be a reliable crowd pleaser. So a Federal Reserve proposal to meddle in Wall Street pay would make a good deal of political sense.

But Fed officials are almost certainly aware that this populist flourish will do little to control risk-taking or stabilize the financial system. There are far simpler and more effective ways to clamp down on reckless bank behavior than seeking to micro-manage bank pay structures.

First, the Fed is certain to be outmatched.

In one corner you have a central bank that has been notoriously spineless on regulatory matters. The institution is crammed with officials who have traditionally seen themselves as defenders of the banking system and advocates of laissez faire.

Even some top Fed officials admit they would need a culture shift in order to take on more regulatory responsibility.

In the opposing corner you have heavy-weight Wall Street institutions with armies of lawyers dedicated to gaming the regulatory system.

There is a deeper objection to the Fed’s effort. The real problem is not the structure of bank pay but its scale.

The received wisdom remains that longer-term incentives will curb risk taking. Lock up bonuses in stock and you will tame bankers. The experience of the 2008 financial crisis screams otherwise.

In the case of Lehman Brothers and Bear Stearns, leading bankers were major shareholders. Richard Fuld was heavily invested in Lehman stock and saw the bulk of his fortune evaporate when the firm collapsed. Ownership does not seem to lower risk.

Other proposals promoted to control recklessness — such as trying to claw back pay if bets go sour years later — look even more misguided. Such schemes would almost certainly create endless bureaucratic wrangling and possibly legal disputes.

The basic point is that government could ban bonuses outright and it would not eliminate the lure of taking risk. Ambitious executives and bankers would still be spurred on by the prospect of big leaps in base pay or other forms of compensation.

The key, then, is to curb the overall amount of risk that banks can take on. The main tool for doing this is by insisting on much larger capital reserves.

This kills two birds with one stone. Tighter capital rules will increase the stability of the financial system and limit the exposure of taxpayers in the event of failure. In addition, tighter capital rules are the most reliable way of bringing down overall bank pay.

To be fair, the U.S. Treasury also has carefully considered plans on bank capital. But it is hard to escape the conclusion that the fuss being made over bonuses is intended merely to create the illusion of action.

In the event that the banks manage to block deeper reform, the Fed and White House need to be able to claim some kind of victory. The public should not be deceived. The attack on bonuses is mere window dressing.

17 comments

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Extremely well-written article. Its clear that the entire “War on Bonuses” is nothing more than misdirection. Whats is also amazing is the degree to which the financial media is willingly playing along with this ruse.

In my opinion, any serious reform would first address how I-Banks like GS or Lehman were able to create Trillion Dollar Balance Sheets in the first place.

It is the unbridled usage of leverage that ensures that these crises keep happening and no amount of bonus restrictions will stop them..

Posted by Sunil Kajaria | Report as abusive

Folks,
It ain’t going to happen. There will be no challenge to banks as long as they can “pay off” politicans. If you and I, ordinary US Citizens, can see ways to control this sort of behavior, anyone else can also and will try to stop the action.
Until we get some sort of “control” over OUR government, we might as well just take a deep seat and ride it out…

Posted by Duke | Report as abusive

The counsel of people like Summers and Bernanke has carried the day rather than the school of thought represented by the likes of Stiglitz, Volcker, Baer and Hoenig. In other words, at the risk of sounding conspiratorial or, worse, leftist, we are left with the established interests having ‘saved the day’ for themselves by placing their losses on the public’s balance sheet.

It would seem to me probable that having restored the ‘established order’ of ‘free market capitalism’ we are likely to face a second phase of downturn at some point, with the government’s resources already ‘all in’.

At that point it may prove interesting.

For the present we have the helpful reminder that any notion we live in a representative democracy is a lamentable joke.

As Summers once put it: THERE ARE IDIOTS.

Look around. We’re it.

Posted by Silent Bob's Invisible Dog | Report as abusive

Paul Volcker tightened, and was blamed. But he saved the system, at the time.

Alan Greenspan talked in riddles, never really tightened .He guaranteed good weather and warm rains for Wall street. They considered him a saint.

The individual banker preferred to think that he produced the risk (allmost) free results and should be paid accordingly.

Posted by klemens Kotowski | Report as abusive

Very well done. The industry refuses and the Government doesn’t have the courage to reform intelligently. Dynamic change is what we need now and it won’t happen. It’ll never be the same.

Posted by Andrew Franks | Report as abusive

Here is the real problem… and Chris, you are right, the Wall Street institutions have their armies of lawyers who can figure out an angel to get around almost every regualtion and they will. That is, until we have the resolve, as a society, to say “You can go this far and no farther. Your predatory lending, mortgage bundling, life insurance bundling and other risky behaviors have created some of the biggest, most expensive and most pervasive problems we have ever had. These problems have hurt every person in this nation. Enough! Here are the laws that will control your behavior. Break ‘em and you, personally, not only go to jail for a very long time, but you surrender all of your ill-gotten gains.”

Posted by Havasu_Liberal | Report as abusive

I thought writers tried to be objective when they wrote articles. How far people go to further their own agenda is ridiculous…

Posted by Joe Someguy | Report as abusive

Notice that nobody talks about the Mob anymore. It’s because the financial “wizards” of the world have stolen and destroyed far more than the Mob ever did. The savings and loan mess a few years back, the dot com bubble, now this financial screwup…..and what’s next??? Next time I’m not so sure that Americans will have such short memories.

Posted by Juan | Report as abusive

[...] reuters Any attack on bank bonuses is going to be a reliable crowd pleaser. So a Federal Reserve proposal to meddle in Wall Street pay would make a good deal of political sense. [...]

[...] reuters Any attack on bank bonuses is going to be a reliable crowd pleaser. So a Federal Reserve proposal to meddle in Wall Street pay would make a good deal of political sense. [...]

Why don’t they just admit that the whole thing is one big casino, and the day that the Fed stops selling Americans (or at least their future tax payments) to China and other countries, the whole thing goes bust because it’s all a bunch of B.S.? Stocks and bonds are speculation instruments. You buy stocks because you speculate that the company you’re investing in is actually going to make money, next year, with the money you’re lending them NOW. But, who really wins these games? The companies themselves, because they make 10 times the money you’ll ever see, and the stock brokers, who skim 10% and more off the whole thing, and then when something goes wrong? Oopsie. Good thing our company is based in the Caymans(with about 30,000 other corporate tax dodgers). It’s a racket. So, shut it down. Let em starve out and die, and crawl back to whatever country they came from. It’s no secret that the middle east is siphoning something like half a trillion a year out of the United States, so a good way to stanch the blood flow is just to shut it all down. Have a one-year Wall St. holiday, even. Make it two. And, if/when they ever re-open it, make sure it’s all structured in such a way that we don’t end up paying rent for homes and apartments to entities in foreign countries, along with tax payments. Who owns all these healthscam companies, again? Can we have that kind of information made public, while you’re at it with the reforms and stuff, there?

Posted by Bert | Report as abusive

Thank you Reuters for the courageous policy of allowing free speech to surface via these blogs. You could go even further and not moderate… Let the people vote out the useless comments and SPAM themselves.

Posted by vlad the lad | Report as abusive

I agree with – Sunil Kajaria an extremely well-written article. Life is about limiting regret, I would argue life is about limiting risk.
DH

What happened to the notion of “free market economy”. The great economist, Adam Smith, proposed that the “invisible hand of the market” would ensure equilibrium in the market but this notion has been replaced by the invisible hand of the central banks.

It seems that there are two major camps in the world today. Those that would like to see smaller government and less meddling in in market and those that prefer the expansion of government and rule of the markets by the central banks. As matters stand now the latter model is the prevailing one but indications are that they are unable to impose their will on the markets. It is similar to a situation of a doctor trying to impose health on a very sick patient. The more the doctor medicates the patient the sicker they get.

Perhaps, Mr. Smith was right that capitalist economies operate most effectively when they are allowed to regulate towards equilibrium through internal dynamics rather than externally imposed regulation?

Bottom line is that if investors dont like the bonus policies of companies then they can choose to invest their money elsewhere or invest their money in a bank that provides better return to customers and investors. Why does the FED have to stick their nose into this issue when their stupid policies of 2001-2007 are responsible for calamitous meltdown of 2008- ?

Posted by Gregory | Report as abusive

Much larger capital reserves is good, but already banks make noises that this will hit the small customers as costlier loans etc. So the idea of linking reserves and total bank presonnel costs (ncluding bonuses)has already been proposed. That is, total py can only be a constant proportionof reserves. Now this kills two birds with one stone.

Posted by Joe | Report as abusive

Gregory ~

With respect: Smith never argued for the form of ‘free markets’ advocates of such markets often claim.

I suggest you check your source.

From my humble perspective I would argue that a market dominated by a very small number of enormous elephants is not ‘free’ in any practical sense. To argue that it is ‘free’ is analogous to Anatole France’s famous observation that ‘the law in its majesty fprbods rich and poor alike from sleeping under bridges, begging in the streets, or stealing bread.’

On the other hand, it seems to me clear that while anything carried to an extreme is ill-advised, whether ‘free’ markets or government, the government of the US as well as its formal and informal governing elites is demonstrably incompetent.

One needs a revolution every few centuries at the least, if only to shake things up.

Ask Thomas Jefferson’s ghost, amongst others.

Posted by superduperatomikhedgehogdave | Report as abusive

“The key, then, is to curb the overall amount of risk that banks can take on. The main tool for doing this is by insisting on much larger capital reserves.”

I think that you have made and error in the above statement. If you or anyone can recall that’s what the bank stress test had covered and was part of the bank bail-out package once a bank had paid the money back.

Posted by Red | Report as abusive

As the world moves toward a post cheap energy future, most of the excess within the modern world’s finances will be wrung out of the system anyway. It is likely that in the 20 to 30 years of life I have left at age 58, that I will see the beginnings of a disintegration of what we have wrought since easily obtained petroleum became available some 150 or more years ago. To believe that the human race will always have a way to expand through new technologies is as silly as a belief in Santa Claus. Old St. Nick’s bag of toys is rapidly becoming so expensive, only a few will find those goodies under the tree. [ assuming that there will be trees available! LOL!] The “First” world will relearn what it means to live with less than the “choices” sold to us today. Of course, I could be wrong, and just a “nattering nabob of negitavism”. Nah…I think not!

Posted by Dirk Ouellette | Report as abusive

No law and regulator can stop determined crooks, criminals and immorality. We have laws against murder for centuries and look how many murders happen each day.

Yes Wall Street elites are determined to impose their criminal ideologies to the world.

Yes Wall Street continue to have a stranglehold on politicians.

Just like the Mafia.

But the Mafia was defeated. How? There is only one way. You completely wipe out their entire personnel from the godfather to the foot solders. That’s what the FBI did, under special laws passed by Congress whose only purpose is to destroy the Mafia.

Will this happen? Of course not. How will the politicians get re-elected then? While only a small number of politicians benefited from the Mafia money, virtually the entire political class can’t make it without Wall Street money. This has been, and will continue to be America until the country is purged.

Posted by The Real Deal | Report as abusive

[...] The Fed’s phony war on bonuses [...]

[...] The Fed’s phony war on bonuses [...]

[...] The Fed’s phony war on bonuses [...]