Fed Finally Acts to Limit Excessive Bank Compensation

by: Bill Zielinski

Bailout Funds Go To Bank Bonuses

Banks that lost billions of dollars on speculative investments and poor loans have routinely been awarding thousands of employees massive bonus payments. Ironically, the only reason many of these banks are still in business and able to pay bonuses is due to the fact that they were bailed out by the taxpayers via the TARP program.

It is difficult to understand the lack of sensitivity exhibited by the banks' compensation committees considering the populist outrage and criticism by politicians from both parties. Consider Bankers Reaped Lavish Bonuses During Bailouts:

Nine of the financial firms that were among the largest recipients of federal bailout money paid about 5,000 of their traders and bankers bonuses of more than $1 million apiece for 2008, according to a report released Thursday by Andrew M. Cuomo, the New York attorney general.

All told, the bonus pools at the nine banks that received bailout money was $32.6 billion, while those banks lost $81 billion.

Some compensation experts questioned whether the bonuses should have been paid at all while the banks were receiving government aid.

“There are some real ethical questions given the bailouts and the precariousness of so many of these financial institutions,” said Jesse M. Brill, an outspoken pay critic who is the chairman of CompensationStandards.com, a research firm in California. “It’s troublesome that the old ways are so ingrained that it is very hard for them to shed them.”

Private firms that risk private capital on high risk leveraged investments should be free to compensate themselves as they see fit. Banks, on the other hand, have been playing a “heads I win, tails you lose” game, risking depositor money (guaranteed against loss by the FDIC), suffering no consequences for bad decisions and collecting lavish bonuses for horrendous results. The issue of why banks are allowed to risk taxpayer money on speculative activities was recently raised by former Federal Reserve Chairman Paul Volcker - Volcker Seeks Bank Limits.

In his speech, Volcker urged limits on the activities of banks that are considered “too big to fail,” going beyond what other officials in the Obama administration have advocated.

“I do not think it reasonable that public money –taxpayer money — be indirectly available to support risk-prone capital market activities simply because they are housed within a commercial banking organization,” Volcker said.

“Extensive participation in the impersonal, transaction- oriented capital market does not seem to me an intrinsic part of commercial banking,” Volcker said. “Substantial involvement in heavily leveraged finance and heavy proprietary trading almost inevitably entails risks.”

“I want to question any presumption that the federal safety net, and financial support, will be extended beyond the traditional commercial banking community,” he said.

Paul Volcker was probably not the only one wondering why banks are operating outside traditional banking areas and risking taxpayer funds. Volcker’s speech seemed to hint that regulators were belatedly preparing to restrict both bonus payments and unwarranted risk taking by the banking industry. Following up on Volcker’s comments, the Federal Reserve Friday proposed dramatic restrictions on both bonuses and risky investment activity by financial institutions.

Wall Street Journal - Policies that set the pay for tens of thousands of bank employees nationwide would require approval from the Federal Reserve as part of a far-reaching proposal to rein in risk-taking at financial institutions.

Under the proposal, the Fed could reject any compensation policies it believes encourage bank employees — from chief executives, to traders, to loan officers — to take too much risk.

The U.S.’s largest banks, about 25 in number, would get especially close scrutiny. The central bank intends to compare these banks as a group to see if any practices stand out as unusually dangerous to their firms.

The Fed itself believes it has the legal authority to take such action through its existing supervisory powers, which are designed to oversee a bank’s soundness.

Pay is now seen as a factor that could make a firm, and more broadly the financial system as a whole, vulnerable to collapse. The financial crisis turned up many examples of how pay can give employees incentives to take risks. One example: loan officers who churned out thousands of low-quality loans in order to claim annual bonuses for themselves.

In a Wednesday speech, Former Fed Chairman Paul A. Volcker noted that one of the causes of the financial crisis “was the ultimately explosive combination of compensation practices that provided enormous incentives to take risks” just as new financial innovations “seemed to offer assurance — falsely, as it has turned out — that those risks had been diffused.”

The policies would apply to banks regulated by the Fed, not savings-and-loans or state banks that are overseen by the Federal Deposit Insurance Corp.

Will Fed Proposals Prevent The Next Banking Crisis?

If the Fed believed it had the legal authority to restrict undue risky activity at financial institutions, the obvious questions is why were these rules not implemented before the banking system imploded? Regulators constantly reacting to disasters after they occur does not instill a strong sense of confidence that new regulations will prevent the next crisis.