Ben Bernanke Calls for Compensation Reform

Federal Reserve Chair Ben Bernanke says something’s amiss with Wall Street’s pay structure:

“Poorly designed compensation policies can create perverse incentives that can ultimately jeopardize the health of the banking organization,” Mr. Bernanke said during a speech in Phoenix to the Independent Community Bankers of America. “Management compensation policies should be aligned with the long-term prudential interests of the institution.”

There are two kinds of issues here. One is what should the government do (or have done) with “normal” financial institutions. In this case, I don’t think it would be appropriate for government to step in and try to tell firms how to pay their traders. But Ben Bernanke and other regulators, charged as they are with prudential oversight of the financial system, could certainly make known to the public their view that certain firms have a compensation structure that does not seem consistent with the long-term prudential interests of the institution.

At the moment, however, there’s the more direct issue of what to do with government-controlled or government-dependent enterprises. Here the case for forthright action is pretty clear. It’s our money, so we should insist that it be given to managers who are compensated in a way that’s aligned with long-term prudential interests. That would mean relatively low salaries and long-term equity in the firm so that you can strike it rich if and only if your work actually pays off well over time.

It’s important to think about this somewhat systematically. Right now there’s populist outrage about bonuses, but we don’t want to just shift to a system of low bonuses and giant fixed salaries. We need comprehensive reform, a la Brad DeLong’s suggestion.