Readers may recall that I solicited their comments on an FDIC Advanced Notice of Proposed Rulemaking on its proposal to link deposit premiums to executive compensation programs (the high concept is to charge higher premiums to banks that reward executives for undue risk-taking. Now admittedly, a program like this would take some thought to make sure it was not easily circumvented (as in measures need to be in place to make sure that banks don’t simply skirt the rule, say by putting risky exposures in off balance sheet entities).
I was going to pen a simple cover note expressing general support and attach reader comments, but I wound up writing up something more substantive. The letter raised a couple of issues that have not gotten the attention they warrant, namely, the need for bank executives and key operating staff to bear greater liability, and the way that the bank merger wave seems to have been driven to a considerable way by the fact that it leads to higher CEO pay post-merger.
Sheila Bair
Chairman
Federal Deposit Insurance Corporation
550 Seventeenth Street, NW, Room 6076
Washington, DC 20429
Dear Chairman Bair,
America can no longer afford to have a banking system that serves the ends of its executives rather than those of taxpayers and communities who have been saddled with cost of reckless profit-seeking. The FDIC proposal to tie deposit insurance premiums to the incentives in executive compensation programs would be an important step forward towards making sure that bank managers operate in a way that reflects the value of the extensive government support and safety nets they enjoy. Bank officers should not be encouraged, as they are now, to take “heads I win, tails you lose” bets with deposits.
There is no question that the annual accounting/bonus cycle is badly out of line with the time horizon of many of the wagers that financial institutions take. Unfortunately, the belief that using stock options or restricted shares as an important part of compensation would lead to responsible behavior has proven wildly false. Both Bear Stearns and Lehman had substantial equity ownership at both the executive level and among the rank and file. By contrast, when Wall Street was dominated by private partnerships, so the management group was jointly and severally liable for losses, the sort of profligate risk-taking that took place in the run-up to the global financial crisis was virtually unheard of.
Unfortunately, all compensation arrangements at public companies are inherently, “heads I win, tails you lose.” No matter how badly a corporate team performs, its pay is immune from clawback, except in the case of fraudulent conveyance in bankruptcy, and even then, the “lookback” period is usually shortly before the failure of the firm. By contrast, it often takes years to reap the bitter harvest of bonus-flattering decisions.
It may be that the only way to cope with the agency problems inherent to risk-taking in a public firms is to make pay arrangements more symmetrical, as in to find ways to recover compensation from executives and senior business unit managers who managed and led programs and products that were ultimately destructive to their companies. The better the arrangements of the old private partnerships can be approximated (admittedly a tall order) the better.
In addition, I would encourage you to think hard about the perverse incentives posed by acquisitions. One of the striking developments in the US banking industry over the last 20 years is an increase in concentration, particularly among the largest players, which has played directly into our current “too big to fail” policy problem. The usual rationale given in greater efficiency, that is, that bigger banking is cheaper. Yet every academic study I am aware of has found the reverse: that once a minimum threshold is reached (there is some disagreement as to where that lies), banks in the US exhibit a slightly negative cost curve, which means the bigger the bank (measured in assets) the higher its cost ratios. Thus the dramatic expense cutting that occurs in the wake of acquisitions could have been done by each of the merged institutions, separately.
Another reason to be skeptical of bank acquisitions is the poor track record of mergers generally. Virtually every academic study ever done has found most mergers “fail” as in they deliver negative outcomes to stockholders.
So why do deals continue? First, there is a large constituency that promotes them because they are particularly lucrative, in particular, investments bankers (who collect M&A and financing fees) and management consultants. A host of other “helpers” such as lawyers and accountants also reaps fat fees from deals.
But the biggest incentive is again flawed executive compensation. Bank CEO pay is highly correlated with the size of the institution, measured by total assets. And the senior team of the acquired bank is effectively bought off via golden parachutes.
I strongly encourage the FDIC to remove the incentive for executives to bulk up their banks solely to pay themselves more. One way might be to require that executive bonuses be set in relationship to the pre-acquisition peer group for a substantial initial period (at least three years, better yet five) and be benchmarked against the new peer group of bigger banks only if the merged entity had met certain operational performance targets.
I also asked readers of my blog, Naked Capitalism, to offer their comments on the proposal that you, Vice Chairman Martin Gruenberg, and Thomas Curry are supporting. They are glad that the FDIC is serous about bank reform and are keen to see meaningful measures implemented to curb executive-serving, public-endangering compensation structures. I am attaching their remarks.
Sincerely,
Yves Smith
7 comments
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I’d go much further. Banks are granted a monopoly on the production of money. They are in effect civil servants.
Their pay should not ever be above that of their regulators.
“Banks are granted a monopoly on the production of money.”
Agreed. People don’t seem to realize what an outstanding privilege that is.
I’m of the view that their pay can be whatever they want. I’m also of the view that in that exercise of independence there comes joint and several liability and the inalienable right to bankrupt.
Or get paid whatever and in the bargain you get to go bankrupt and quite probably to jail. I’d go even further, a real jail, not Club Fed.
It is the only way to deal with this problem. Bank boards are zombie boards. What system on God’s green earth, allows you to hand-pick your bosses? Delaware corporate law! When CEOs can decide who their paymasters are, then it is no surprise that the metrics are skewed towards them getting fatter and fatter paychecks and executive agreements that enshrine the “heads I win, tails you lose” ethos.
Duties of loyalty, candor and care used to mean something but have been watered down by the Delaware courts who can’t abide a system that would make that state less important for forum-shoppers.
Comp committees need to be beefed up to the level of audit committees as to professionalism and independence (and personal friendships and loyalties need to be disclosed and snuffed out). In this way,negotiations for bank executives can finally become truly arms-length.
Comp consultants and comp lawyers need to decide who they are going to represent – boards or employees – and stick to that instead of this incestuous commingling which makes impressing possible future clients way more important than getting the best deal for the client you have now. That more than anything explains the sharp upward trend of pay since the early 90s. We need to shift the incentives so that the middlemen start bragging about how they negotiated DOWN pay packages rather than how much they pushed them UP.
This is a very good point. Forum shopping almost always leads to a race-to-the-bottom that the unscrupulous and lucky win (in exchange for very meager benefits to the “winning” forum).
This is obviously a matter of utmost importance to interstate commerce, and all banks should be subject to strict federal regulation of corporate governance.
Siggy,
Since we went down the path of a mythical construct by the powers that be that such a thing as TBTF exists (even if such a construct can never be proven ~ and in fact has throughout thousands of years of social history been proven not to exist) the onus is on the FDIC and US govt to render palatable bank pay structures to the true owners of these institutions, that of the US taxpayer.
The issues you addressed (governance and size) are I think the main ones given cowboy culture. I’m always pleased when discussion of governance refers back to the partnership model.
As this Mess grinds on, I hope we’ll come to the Canadian conclusion that (as bob mentions above) finance is no place for cowboy culture. The Volker Rule is a move in this direction. I happen to think it’s aimed more at providing political cover should we experience another period of “long weekends” as in Fall 2008. Which I believe we will, sooner rather than later, but regardless it’s a move in the right direction.
The change I have in mind is more cultural than regulatory or legal. I believe NC is encouraging such change, so I’ll take this opportunity to again say Thank You Yves!