What’s wrong with financial-industry compensation? In a nutshell, bank executives are lavishly rewarded if they deliver big short-term profits — but aren’t correspondingly punished if they later suffer even bigger losses. This encourages excessive risk-taking: some of the men most responsible for the current crisis walked away immensely rich from the bonuses they earned in the good years, even though the high-risk strategies that led to those bonuses eventually decimated their companies, taking down a large part of the financial system in the process.
The Federal Reserve, now awakened from its Greenspan-era slumber, understands this problem — and proposes doing something about it. According to recent reports, the Fed’s board is considering imposing new rules on financial-firm compensation, requiring that banks “claw back” bonuses in the face of losses and link pay to long-term rather than short-term performance. The Fed argues that it has the authority to do this as part of its general mandate to oversee banks’ soundness.
This makes sense to me, though I’m moderately skeptical it can really be made to work in practice.
But I do think it’s worth dwelling on the fact that this really a pretty odd situation. Who doesn’t the market take care of this problem itself? It really seems like investors would be reluctant to deal with financial institutions that are organized this way. It seems like there was a reason the major investment banks were traditionally organized as partnerships—partnerships don’t have these incentives, and people should prefer to do business with institutions that don’t have these incentives. But the market’s not working like that. And it’s worth trying to understand why. If regulators start playing cat-and-mouse with compensation shenanigans, the mice are probably going to wind up winning. But if there’s some specific thing that’s preventing market discipline from adequately aligning incentives, we ought to be trying to find out what it is and what can be done about it.