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.

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