Should Fed have say on banker pay?

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Washington's bureaucratic warriors are strapping on their armor to fight for control of how Wall Street pays its people. The Fed is letting it be known that it does not want the Treasury's special master for executive compensation -- a.k.a., the Comp Cop, Kenneth Feinberg, to have the last word. There's some good news buried in the Fed's proposal -- it wants banks to delay paying bonuses for a few years to see whether bankers' deals lose money.

Before getting into the details of the Fed's proposal, it's worth noting that banker pay is no side show -- it's the biggest thing out there when it comes to banks. As much as 70 percent of bank revenue goes to pay bankers. Bankers work 100 hour work weeks for the hope of having one good day a year -- when their bonuses are announced. A big reason the financial crisis happened is that bankers did whatever was necessary -- including closing big deals in the short-term regardless of future losses from those deals -- to secure ever-higher bonuses.

For years, I have been feeling like a broken record -- arguing since July 2007 and many times since -- that banker bonuses should go into escrow. If the deals that bankers originate end up making a profit for investors after a few years, the bankers get the money in escrow. If the deals lose money, the escrow accounts flow to the investors who've been harmed. I believe that this kind of incentive system would force bankers to originate better deals since their pay would be tied to both their deals' riskand return.

Now the Fed is proposing to regulate the pay and bonuses of top executives, traders, loan officers and others. The 20 largest financial institutions (FIs) would have to present their compensation plans to bank regulators, who could then demand changes. The Fed rules would also apply, in a different form to a total of 5,000 FIs.

So while the comp cop's work pertains to paying executives at FIs with Troubled Asset Relief Program (TARP) money -- which will overlap with the Fed's jurisdiction -- the Fed's proposal would apply after the TARP is history.

The Fed proposes to alter the structure of bank compensation rather than the amount -- with the idea of discouraging FIs from paying people to take on too much risk. The Fed is adopting three principles:

  • Defer bonus payment. Fed examiners would see whether FIs defer bonuses for several years to see whether risks and potential losses would surface;
  • Punish risk. They would examine whether FIs pay smaller bonuses to those who take greater risk; and
  • Take-back bonuses retroactively. And they'd check whether FIs can "clawback" bonuses if profits evaporate after an executive gets paid.

One of the biggest conceptual problems with the Fed proposal is that it leaves open what is meant by risk. That may sound academic, but the simple fact is that one of the biggest practical problems with the Fed proposal is that what looked very safe for years might end up being disastrously risky in the future. Moreover, by encouraging FIs to pile into that historically safe activity, the Fed might inadvertently create the kind of market behavior that forces participants to turn that activity from safe to risky.

Also, it's pretty clear that if the Fed rules go into effect, bankers who can do so will bolt to FIs that are not subject to the Fed's pay limitations. After the recent financial crisis, it's not clear whether the resultant brain drain from FIs covered by the Fed rules would be a good or bad thing.

But one thing I am sure of is that if you give economic power to people and encourage them to take short-term risks to boost their bonuses, that's just what they'll do. That's why I'll keep talking about the idea of putting their pay in escrow.

Peter Cohan is a management consultant, Babson professor and author of eight books including, You Can't Order Change. Follow him on Twitter.

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