Question

"Freakonomics" is a best selling book on unexpected applications of economics. The authors have a website to accompany the book. On the "Freakonomics" blog, a topic of discussion was "What if We Paid Bank Regulators for Performance?" If banks fail (that is, go out of business) as many did in 2008 - 2009, the regulators would not earn much money. If the banking system is healthy, the regulators would receive a bonus.

Do you think this is a good idea or a bad idea? Why? Keep in mind that the bonuses would be for regulators, such as officials at the Federal Reserve, and not for the bank executives. Be sure to include in your discussion what the goals of financial regulation are, and how this plan would affect those goals.

Answer 1

Goals of Financial Regulations

Since BFSI(Banking, Financial Services & Insurance) sector involves a large amount of public money, the major goals of the financial regulators across this sector are to instill financial discipline and mitigate any risk affecting the public confidence and restoring the credibility of the industry.

Has executive compensation contributed to the financial crisis?

In the aftermath of the financial crisis, there has been no shortage of finger-pointing in an attempt to identify its underlying causes. The list of potential culprits is long and ranges from bank deregulation to the “alchemy” of credit ratings and structured finance. This debate focuses on one factor that has allegedly contributed to the crisis: greedy bankers and the executive compensation packages that tempted them to, quite literally, bet the bank.

The spectacular collapse of banks whose executives were allegedly paid for performance raises many questions about the link between executive pay and risk-taking. paper, Thomas Philippon and Ariell Reshef of New York University show that while in 1980 bankers made no more than their counterparts in other parts of the economy, by 2000 wages in the financial sector were 40% higher for employees with the same formal qualifications. The last time such a discrepancy was observed was just before the Great Depression—an irony which has not been lost on critics of bank compensation, ranging from regulators to the Occupy Wall Street protesters. But the level of compensation alone may not be the real problem. Many leading economists (see, for instance, op-eds from Alan Blinder and Raghuram Rajan) have emphasized that a much more important (and difficult) question to answer is how the structure of performance pay may encourage excessive risk-taking at all levels of the institution, from traders and underwriters right up to the firm’s CEO.

But how exactly the structure of executive pay affects risk-taking is still a topic of heated debate. Some have argued that—even before the crisis—executive compensation at banks had several features that should have discouraged short-termism and excessive risk-taking: paying bankers with equity or stock options, for instance, should ensure that if the firm’s market value gets wiped out the same fate awaits the paycheck of its senior management. But matters may be more complex. Incentive schemes may emphasize immediate revenue generation over a prudent long-term assessment of credit risk (as was likely the case in mortgage lending), and bonuses awarded today may entail risks that do not become apparent until much later. Both aspects of bank compensation have become the focus of increased regulation intended to discourage bank executives from excessive risk-taking. But our understanding of how incentives at banks translated into actual risk-taking behavior are still limited and regulators struggle to come up with rules that can rein in reckless risk-taking without extinguishing banks’ ability to reward actual performance.

What do you think? I've asked Rene Stulz of Ohio State University and Lucian Bebchuk of Harvard Law School to kick off the debate. Please join us and let us know which side you are on. They'll be posting opening statements later this week on the question: "Has executive compensation contributed to the financial crisis?" The comments section will be open, and we'll also be featuring a poll that will allow our readers to weigh in on the issue.

What if We Paid Bank Regulators for Performance?

A new paper by two law professors, Frederick Tung of Boston University and M. Todd Henderson of Chicago, proposes just that. Here’s the abstract (with a link to the full paper):

Few doubts that executive compensation arrangements encouraged the excessive risk-taking by banks that led to the recent Financial Crisis. Accordingly, academics and lawmakers have called for the reform of banker pay practices. In this article, we argue that regulator pay is to blame as well and that fixing it may be easier and more effective than reforming banker pay. Regulatory failures during the Financial Crisis resulted at least in part from a lack of sufficient incentives for examiners to act aggressively to prevent excessive risk. Bank regulators are rarely paid for performance, and in atypical cases involving performance bonus programs, the bonuses have been allocated in highly inefficient ways. We propose that regulators, specifically bank examiners, be compensated with a debt-heavy mix of phantom bank equity and debt, as well as a separate bonus linked to the timing of the decision to shut down a bank. Our pay-for-performance approach for regulators would help reduce the incidence of future regulatory failures.

Impact of the above Proposal

The proposal would completely change the role of the regulator, from antagonist to partner. The authors think this would lead regulators to use the private information they learn on the job, not only to improve their pay, but also to send indirect signals to the market by acting to curb excessive risk-taking at a particular bank. This would ultimately improve transparency, and lead to fewer instances where the market has a wrong view on a bank’s value.

But there’s a reason people go into government work and not the private sector. Would pay incentives even work on them, given their “public-spirited motivations?” In light of the recent failures of merit-pay for public school teachers, maybe not, but the authors balk at the notion that regulators are sufficiently motivated, given their dismal performance in the financial crisis.