24 Sep 2009

How to Predict the Coming Bank Pay Regulation

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How to Predict the Coming Bank Compensation Regulations
By Robert P. Murphy

In an article that convinced half my readers I was a genius, and half that I was completely insane, I argued that the way to predict the coming moves in currencies and other major financial events was to put yourself in the shoes of the extremely powerful elites who are running the show behind the scenes. Let’s apply that general approach to the specific question of the promised “reform” of compensation at financial institutions. There are more recent articles, but this WSJ story from last week has some great quotes to illustrate my points.

First of all, we need to drop Ayn Rand’s view that big businesses are a persecuted group. Yes, it’s true that governments keep the best legitimate businesspeople from achieving the success that they would on a free market. But what that means is that the potential big businesses are persecuted. Precisely because of onerous government regulations, there is prima facie suspicion that huge businesses right now are using the government to enrich themselves and/or hobble their competitors.

One of the most eye-opening moments in my undergrad education occurred in a Public Choice lecture by Gary Wolfram. Gary (I worked with him later on, so I can call him by his first name now) explained to us that the federal regulations banning cigarette advertisements in many outlets (notice you don’t see Marlboro ads during football games?) were supported by the big tobacco companies. Isn’t that counterintuitive? Fresh from reading Atlas Shrugged, wouldn’t you have guessed that the tobacco executives were throwing darts at pictures of bureaucrats when the new regulations went into effect?

Gary’s explanation was that the tobacco companies had found in their research that advertising didn’t bring in many new smokers, but mostly stole market share from other brands. So if all the tobacco companies could agree to cut back on their advertising, they would all make more money. But of course, that kind of cartel would be hard to police in a free market, especially since a new upstart brand could come in with a big advertising campaign. But the plan could work if the government punished any cheats with big fines. Hence the big tobacco companies benefited from these particular rules, while smaller tobacco companies–especially ones that had a better (in the relevant sense) product–were stifled.

Let’s switch topics now to financial institutions. Let’s suppose the CEOs [UPDATE: It makes more sense to say the major shareholders, not CEOs, have the below conversation, but I’ll leave the dialogue in the original form.] of Goldman Sachs, JP Morgan, and a handful of the other big boys are sitting in a smoke-filled backroom talking shop. The conversation might go like this:

CEO A: “Boy, wouldn’t it be great if we could cut the salaries we pay to our employees across the board? Man, that would be great. It’s not like our top people would go into hotel management or start driving a cab. They’d stick with our firms.”

CEO B: “Yeah, but we could never all agree on the rules and enforce them. Besides, if the public caught wind of it, we’d be toast. Remember the fiasco with the chartered jets?”

CEO C: “Well, what if we got the feds to impose the rules? We could spin it so that it was designed to protect the public from risky positions.”

CEO B: “Give me a break, the public wouldn’t go for that. What if the government proposed cutting teachers’ salaries by 10% across the board in order to raise graduation rates? It’s absurd. We need a better angle.”

CEO D: “Nah nah, he’s onto something there. We could make this work.”

CEO B: “OK fine, let’s assume for the sake of argument that the public buys it. Still, we’d lose our best talent overseas. The SEC and the Fed can’t tell Deutsche Bank how much they can pay their top execs, at least not ones based outside the US.”

CEO A: “Well, what if we got all the major governments on board? Our overseas friends would benefit from the arrangement just as much as we would. The only important thing, would be to install a system that keeps us all honest.”

CEO B: “You guys are crazy. Look, part of our advantage is that we can recruit the best talent. If there is an industry-wide cap, some of our best people might switch to our competitors. How are you going to get people to move to Manhattan, if you can only pay as much as a bank based in Charlotte?”

CEO C: “I got it! We’ll make the new compensation rules favor the big banks. So there will still be overall caps, but the biggest banks will still be able to offer the most lucrative compensation packages, relative to their smaller competitors.”

Is the above a paranoid delusion? You tell me. Here are some choice excerpts from the WSJ piece of September 18:

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.

The U.S.’s largest banks, about 25 in number, would get especially close scrutiny. The central bank intends to compare these banks as a group to see if any practices stand out as unusually dangerous to their firms.

The proposal will likely push banks to use “clawbacks” — provisions to reclaim the pay of staffers who take risks that hurt their firms — in certain pay packages, among other tools, to punish employees for taking excessive risks with their firms’ money.

The Fed’s planning comes amid an intensifying global debate about the way bank employees are paid ahead of the Group of 20 meeting of world leaders in Pittsburgh next week. U.S. and foreign officials worry that if they don’t coordinate their rules, some countries could draw talent away from others.

On Thursday, European Union governments issued a communiqué urging the G-20 to adopt strict rules to restrict bonus payments. Speaking after the meeting of EU leaders in Brussels, French President Nicolas Sarkozy said he would support the idea of linking the size of bonuses at each bank to their level of capital.

My tip: If you want to anticipate how these new rules will shake out, just suppose that they are actually being designed by the world’s richest bankers. Because they are.

Robert P. Murphy holds a Ph.D. in economics from New York University. He is the author of The Politically Incorrect Guide to the Great Depression and the New Deal (Regnery, 2009), and is the editor of the blog Free Advice.

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