Should the Fed Regulate Banking Sector Pay?

I see a good case for this, but also some big things to worry about.

Today’s Wall Street Journal reports:

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.

The Fed’s plan would, for the first time, inject government regulators deep into compensation decisions traditionally reserved for the banks’ corporate boards and executives.

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. Bureaucrats wouldn’t set the pay of individuals, but would review and, if necessary, amend each bank’s salary and bonus policies to make sure they don’t create harmful incentives.

One of the key questions for understanding the causes of our current problems is the following. Suppose that in 2005, the individuals who were putting together securities derived from subprime and alt-A mortgage loans could have known, with perfect foresight, events that were going to unfold in 2008. Would they have still done the same things they did in 2005? My concern is that, for many individuals, the answer might be “yes”, insofar as they were richly rewarded personally in 2005 for making exactly the decisions they did. It was other parties (namely you and me) who later down the road were forced to absorb the downside of their gambles. Capitalism functions well when individuals are rewarded for making socially productive decisions. It is a disaster when individuals are rewarded for making socially destructive decisions. For this reason, I am quite supportive of the broad idea of the above proposal.

I would nevertheless raise an important cautionary note: whenever one introduces more regulations, one is simultaneously creating enormous pressure for those being regulated to try to take over the regulatory process. I would urge the Federal Reserve to be thinking carefully not just about details of the economically desirable incentive structure for bank managers, but also to attach equal importance to protecting the Federal Reserve itself from regulatory capture. Here are some general objectives which they might want to keep in mind.

Openness and transparency. Details of all regulations should always be extremely transparent and public, with high-profile communication of any proposed changes. I was unable to locate a public release of the specifics of the Fed’s proposal, but gather that the WSJ story was based on off-the-record statements from “people familiar with the matter”. I think one of the best disinfectants for preventing regulatory capture is to keep as bright a light as possible shining on all details of the regulatory process.

Simplicity and uniformity. The goal here is to be very clear about the basic principles we’re trying to implement and make sure they’re applied broadly, fairly, and consistently. Although the Fed is used to thinking in terms of preserving its discretion, it’s important that these regulations be implemented in a transparently uniform way.

I see this is as an important step to take. But it’s also very important for the Fed to realize they’re walking into a minefield.

Regulating compensation in the banking sector

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