Compensation: Banking's Dirty Little Secret

Banking’s dirty little compensation secret is that most of the fury over bank executive pay limits is fake. Since the formation of the FDIC during the Great Depression, Federal regulators have had the legal authority to limit bank pay and have regularly used that authority. But vocal Administration critics seem to be intentionally misleading the public about this issue by pretending that regulation of bank pay is a new issue. Not only has the Federal government directly and indirectly regulated most financial services compensation for decades, but Federal officials have a legitimate public policy interest in doing so. It is neither “socialist” nor “Marxist” for the Obama Administration to look at bank pay but rather good public policy. Bad bank compensation is like the swine flu; it kills its host.

Critics don’t seem to understand that in the U.S. the opportunity to own, operate or use a bank is a “privilege” and not a “right”. As with most privileges, banking has both limitations and responsibilities that are imposed by the government. If executives want the privileges and benefits that come with banking they need to accept that executive compensation is going to be reviewed and limited by regulators.

Over the last 25 years I have personally been in many meetings with Federal regulators where executive compensation was discussed, including at times my own compensation. I understood that if I wanted to be employed in an executive position by a bank my compensation would be reviewed and potentially restricted by regulators. I know that my experience isn’t unusual for small and mid-size bank executives.

What is different about today’s debate is that it now includes the “big guys” being asked about their compensation and isn’t just restricted to executives of small banks. The big guys thought that they were above the regulatory worries of the “little people”. After all, in the banking industry “bigger” is “banker code” for “bigger compensation”. It never occurred to big banks that size might not matter and compensation could actually be tied to performance.

Even worse, many big bank executives believe in Wall Street’s “what have you done for me lately” compensation culture. But unlike prior generations of bankers, the compensation culture has been turned inside out. Today’s managers worry about what the bank has done for them lately and not what they have done for the bank. And, they squeal when their compensation is tied to such trivial objectives like getting loans repaid or earning money over the course of a business cycle.

Access to government programs like FDIC deposit insurance provides business opportunities that aren’t afforded to non-banks. FDIC deposit insurance allows banks to borrow money using U.S. government credit rather than their own ability to repay borrowings. This is a unique business advantage that banks enjoy which isn’t afforded to other companies. But use of government guarantees has a price. After all, once the U.S. government guarantees the obligations of a bank, typically through FDIC deposit insurance, the U.S. government becomes the largest and most important creditor of the bank. And, like all creditors, the U.S. government has a legitimate economic interest in making sure that its borrowers remain creditworthy entities, don’t pay out too much of their capital to employees and have compensation systems that encourage strong fundamental financial performance.

Bankers understand why compensation is important to creditors. After all, virtually every bank loan directly or indirectly tells borrowers how much they can pay employees. In some cases, banks directly limit total borrower employee compensation while at other times such limits are indirectly imposed through minimum net worth requirements and minimum earnings tests which would be violated if compensation is excessive.

Bank executives obviously don’t believe “what is good for the goose is good for the gander” because when their principal creditor, the FDIC, attempts to impose the same standards on banks as banks impose on bank borrowers, bankers cry foul and accuse the Obama Administration of starting down the path to socialism.

While bankers act as if non-bank, broker dealer and investment banking affiliates of banks are beyond the reach of Federal Regulators, that isn’t true either. The Federal Reserve is the primary regulator of bank holding companies and is supposed to ensure that they are operated in a safe and sound manner. In its regulatory role, the Federal Reserve has plenty of statutory authority to make sure that compensation plans for unregulated non-bank subsidiaries of bank holding companies are appropriate.

The Federal Reserve also can have a say on broker dealer compensation because it touches virtually all of the large broker dealers by virtue of the “primary dealer” program. Primary dealers have unique privileges and profit opportunities in the business world. They are the only firms that have the right to underwrite and distribute securities for the largest borrower in the world, the U.S. government. Once again, with rights come responsibilities. The U.S. government has a legitimate business interest in making sure that the primary dealer community is financially healthy and not taking on excessive risk because of bad compensation policies. At various times in recent history, such as when Solomon Brothers engaged in bid rigging, bad compensation policies resulted in bad primary dealer behavior. The Federal Reserve, through the bi-lateral contracts that it executes with primary dealers, has the ability to change compensation practices and policies of most of the brokerage community. No new acts of Congress are required for the Federal Reserve to exercise its resolve; the Federal Reserve only needs the institutional will to make change happen.

The compensation debate makes it look like bank executives think that they are an entitled class, a class that has underperformed but been overcompensated. Corporate borrowers who themselves are subjected to proctologic examination of their compensation by banks understand at a gut level the compensation debate’s hypocrisy. The Obama Administration seems in touch with the feelings of most of America while the media and bank executives seem to be falling behind popular opinion. It would be nice, however, if the debate over bank compensation started with facts, figure and the reality of 75 years of regulatory experience.

Comments

[Joe Siegel:]

No, owning a bank is not a privilege. I beg to differ; it is a right in the free marketplace. If you can raise capital, gain customers, and make a profit (maybe) by raising deposits and lending under existing fiduciary guidelines and regulations, then that is your business. (Pun intended.) The day we consider starting and running a business a "right" bestowed upon us by the government, is the day we say goodbye to any last remaining vestige of entrepreneurialism, and say hello to a stodgy, non-productive and statist European style social welfare state.
Re: your above statement, it IS Socialism and Marxism for big brother to maintain a right to bestow or not bestow his blessings on our desire to raise funds, assume risk, and make a go of starting up a bank.

May 20 02:12 PM

[PorterPound...:]

Your above essay seems to exclude a fundamental concept of economics: law of supply and demand. Bankers pay scales are determined at arms-length between willing buyers and willing sellers of the services being performed and compensated. Any talented "banker", at any level in the organization, will simply walk away and obtain a position with either a competitor or a non-regulated financial company if not adequately compensated at their present position. I'm sure that is how you determine who you work for and at what comp level. Are you saying the banking industry should be any different? If the banking industry should only get paid what some regulatory wonk says they should get paid, you then have sub-par performers running the bank. Not a world I want to see happen.

May 20 02:48 PM

[D. McHattie:]

I can't agree with you Joe.

Banks create money, a power which our constitution gives only to Congress. Yes, the federal reserve plays an intermediary role but, in essence, private banks create money.

If we don't place some limits on bank executive compensation then they will continue to increase their salaries and bonuses until they are paid hundreds of millions despite losing billions for shareholders. Which is exactly where we are now.


On May 20 02:12 PM Joe Siegel wrote:

> No, owning a bank is not a privilege. I beg to differ; it is a right
> in the free marketplace. If you can raise capital, gain customers,
> and make a profit (maybe) by raising deposits and lending under existing
> fiduciary guidelines and regulations, then that is your business.
> (Pun intended.) The day we consider starting and running a business
> a "right" bestowed upon us by the government, is the day we say goodbye
> to any last remaining vestige of entrepreneurialism, and say hello
> to a stodgy, non-productive and statist European style social welfare
> state.
> Re: your above statement, it IS Socialism and Marxism for big brother
> to maintain a right to bestow or not bestow his blessings on our
> desire to raise funds, assume risk, and make a go of starting up
> a bank.

May 20 03:28 PM

[CGP:]

Bankers earn a "right" to be in a field where they are highly compensated relative to the general population. They are given competitive advantages by the government not afforded the general business population because the financial system serves a purpose for the government and theoretically the economy & people as a whole. Implicit in that "contract" is that they strike a relatively fair balance between individual gain and the health of their own company and by extension the financial system as a whole.

We are where we are today because individual gain came before the health of the system, it was taken for granted. The golden goose almost got strangled to death.

It seems to me the game is one of peers and relativism. If so, how can judgement be passed on Somali pirates? Seemingly their best prospects were to hijack ships on the open sea for ransom. They hadn't really hurt anybody and the shippers were very cooperative in paying up. The smartest pirates are very creative, employing mother ships to extend their reach.

Justification? Somalia is a very poor country, how else can they feed their families? Warlords serving their own fiefdoms and self interest destroyed the country. Who's going to fix it? the warlords? What do they need? A government keeping a lid on things.

May 20 05:16 PM

[a banker:]

I disagree. It is a priviledge and that is why you require a specific license with which comes certain responsibilities. In effect the license gives you a conditional right to do the business of banking as long as you fulfil certain responsibilities.


On May 20 02:12 PM Joe Siegel wrote:

> No, owning a bank is not a privilege. I beg to differ; it is a right
> in the free marketplace. If you can raise capital, gain customers,
> and make a profit (maybe) by raising deposits and lending under existing
> fiduciary guidelines and regulations, then that is your business.
> (Pun intended.) The day we consider starting and running a business
> a "right" bestowed upon us by the government, is the day we say goodbye
> to any last remaining vestige of entrepreneurialism, and say hello
> to a stodgy, non-productive and statist European style social welfare
> state.
> Re: your above statement, it IS Socialism and Marxism for big brother
> to maintain a right to bestow or not bestow his blessings on our
> desire to raise funds, assume risk, and make a go of starting up
> a bank.

May 20 05:50 PM

[Joe Siegel:]

To "a banker". You are correct in the fact that banking requires a license. But so do plumbers, pilots, etc etc. They have specific responsibliites too, but not implicit in those responsibilities is having specific pay scales based on someone's (House Financial Services Committee perhaps?) personal morals and ethics determine compensation? I can not think of one bit of regulation that has increased the efficiency and profitibility of a private entity. Ref: Sarbonnes Oxley, the Communitry Reinvestment Act, The Great Society and so forth.

<<<I disagree. It is a priviledge and that is why you require a specific license with which comes certain responsibilities. In effect the license gives you a conditional right to do the business of banking as long as you fulfil certain responsibilities.>&...

Re: D. McHattie above. I may need some enlightenment, but I don't see how banks create money. The Fed can create money back actually having the Bureau of Printing and Engraving roll the presses, or in the usual way of buying bonds from the bank to increase liquidity. The banks can increase or decrease the velocity of money, which I suppose in some loose way could be construed as "creating money", but describing this as violating the Constitution is a bit of a stretch?

May 20 06:39 PM

[a banker:]

Don't get me wrong. I do not believe that anyone (i.e. except shareholders and board) should necessarily regulate compensation. However, various "banker" behaviours have given the regulators and government the moral high ground to involve themselves. In addition, to the extent that the regulator is (unfortunately) a shareholder in the industry, then they have paid for the right to have a say on executive compensation.


On May 20 06:39 PM Joe Siegel wrote:

> To "a banker". You are correct in the fact that banking requires
> a license. But so do plumbers, pilots, etc etc. They have specific
> responsibliites too, but not implicit in those responsibilities is
> having specific pay scales based on someone's (House Financial Services
> Committee perhaps?) personal morals and ethics determine compensation?
> I can not think of one bit of regulation that has increased the efficiency
> and profitibility of a private entity. Ref: Sarbonnes Oxley, the
> Communitry Reinvestment Act, The Great Society and so forth.
>
> <<<I disagree. It is a priviledge and that is why you require a specific
> license with which comes certain responsibilities. In effect the
> license gives you a conditional right to do the business of banking
> as long as you fulfil certain responsibilities.>&...
>
> Re: D. McHattie above. I may need some enlightenment, but I don't
> see how banks create money. The Fed can create money back actually
> having the Bureau of Printing and Engraving roll the presses, or
> in the usual way of buying bonds from the bank to increase liquidity.
> The banks can increase or decrease the velocity of money, which I
> suppose in some loose way could be construed as "creating money",
> but describing this as violating the Constitution is a bit of a stretch?
>
>

May 20 07:31 PM

[Joe Siegel:]

To "a banker". Even if I would agree that with the Fed owning preferred shares that gives them the right to regulate compensation, why would they want to do so? Chasing those away that have the inside knowledge to unravel this Gordion knot seems unproductive. Only the board etc knows who is valuable enough to keep on board with market based compensation. Also re: their behaviors, yes, there was some pretty outrageous leveraging, but if not for the govt in the first place thru implicit guarantees of the GSEs no matter how under capitalized they were while pushing no or almost no downpayment sub primes via the CRA, and then selling the MBSs accordingly, this never would have happened. Once again, the road to serfdom is paved with good intentions.
Regards


<<<Don't get me wrong. I do not believe that anyone (i.e. except shareholders and board) should necessarily regulate compensation. However, various "banker" behaviours have given the regulators and government the moral high ground to involve themselves. In addition, to the extent that the regulator is (unfortunately) a shareholder in the industry, then they have paid for the right to have a say on executive compensation.>>>

May 20 10:23 PM

[Investor54:]

Banks don't create money any more than pyramid selling scams do. On the back of an accounting framework that has enabled them to use 'optimistic' ballooning asset valuations and book (and be rewarded) on unrealised profits, we have seen something akin or at least comparable to a Ponzi Scheme. The muggins at the bottom were the pension schemes and other investors sucked in as banks sought to disintermediate themselves from and pass-on the exposures, pushing the risk down the chain, while drawing in ever more funds to sustain the bubble/scheme.

May 21 08:24 AM

[User 365483:]

I think it's important not to forget that the government backs banks with a guarantee (FDIC) and as a stakeholder of sorts, has the right to dictate regulation, including comp. Bankers agree to such regulation as a "right" (or "privilege") of doing business in that arena. If we were discussing any other non-regulated businesses, I would whole-heartedly agree that the government should keep its hands off exec comp, unless of course the company is being bailed-out by taxpayers' money. To the argument that you can't get good people at a reasonable price, well, how 'good' were the people with excessive pay packages that ran the "too-big-to-fail" institutions into the ground?

May 21 09:37 AM

[CGP:]

If somebody is mercenary enough to leave solely because of pay, ultimately how valuable are they? Reasonable should be the guideline, not excessive exponential pay hikes and constant one-upmanship.

May 25 01:32 PM