As the Financial Crisis Inquiry Commission cranks up and begins to look at substantive issues, you can expect me to begin commenting more frequently on financial policy issues. I expect that my thinking will evolve as I learn more over fourteen months in the Commission’s lifetime, so please don’t be surprised when you see that reflected in my posts. I may also test out some positions and ask for suggestions as I do below.
Senate Majority Leader Reid’s floor speech last Monday attracted my attention. Titled “Wall Street Narrowmindedness,” it is a broadside attack on the financial sector from the fourth most powerful person in Washington (Bernanke is #2.)
It is tempting to dismiss Leader Reid’s remarks as opportunistic demagoguery, but they forced me to think harder about my views on this important topic. I will follow each of his views with my comments. I am paraphrasing his arguments except where I use quotation marks.
Sen. Reid (paraphrased): People on Wall Street were and still are greedy.
Yes, many of them act that way. That shouldn’t surprise anyone. Our system assumes people will work in their own self-interest, on Wall Street and throughout the country. If doing so results in bad outcomes, then it’s the rules that are messed up, not people’s behavior. Any policy based on the presumption that people will say, “No, stop, you’re paying me too much” is naive and won’t work. Policies need to assume that in compensation decisions most people will generally act as if they are greedy, and channel those base instincts toward an ultimate good. That’s the whole invisible hand thing.
Sen. Reid: They are still paying themselves enormous compensation packages, but now in part with taxpayer dollars.
This is the hard one for me because it gets into multiple and conflicting roles of government. As a general rule I believe government should stay out of compensation negotiations between labor and management. I hate getting the government involved in anyone’s compensation, but there are conflicting policy goals when taxpayer funds are involved. There are countless examples of the government appropriately imposing restrictions on firms when it acts as a purchaser using taxpayer funds rather than as an impartial rule maker. The USG now acts as an investor in TARP banks, Fannie, Freddie, and AIG, and it seems reasonable for an investor to place requirements on the firms in which it invests. The same logic would apply to GM and Chrysler. Those requirements can, in my view, include reasonable compensation limits. This is easier when those investments are supposed to be temporary.
But this view leads me to two problems:
- an unwinding problem: Some (probably on the left) may be tempted to leave the taxpayer funds in the firm so they can continue the limitations. If we have to invest, as I believe we did with TARP, I want both the investments and the rules to be temporary, and to set up a system where the firms are encouraged to repay the taxpayer and remove the restrictions as quickly as possible. This is what we tried to do with TARP.
- two slippery slope problems: By crossing the line and saying I’m OK with compensation limits in this case, I have to differentiate it from other cases where some on the left will argue for compensation limits. Sen. Rockefeller, for instance, tried to limit the compensation of health insurers in a Finance Committee markup. In addition, I don’t think the government should be telling these firms how and to whom they should lend, but the line quickly gets fuzzy.
Sen. Reid: The structure of their compensation packages is encouraging them to jeopardize the financial system … to swing for the fences and make deals that put their entire firms and the larger system at risk.
This is the “excessive risk” argument, which I don’t feel I understand well enough. Some people argue that certain derivatives and trading contributes little economic value and therefore “should not” be rewarded. My instinct is that this is a decision for the firm’s managers … if they want to reward their employees for something that is non-economic, that’s their mistake to make. If instead this non-economic behavior is benefiting the firm owners and employees only by shifting risk to the taxpayer, then I want to know what policies allow or create incentives for this behavior, and then look at fixing those rules, instead of coming in on the back end and clumsily limiting compensation.
I wish someone could show me a specific compensation package which leads to firm-jeopardizing and system-jeopardizing behavior. And I don’t understand how the government should define “excessive.” I could use some help here if anyone has it.
Sen. Reid: Financial sector employees should not get compensation so much larger than that of an average American worker, especially when the economy is weak.
This is just scary. With “financial sector employees” he’s talking about an entire industry. Senator Reid is saying Washington should determine relative compensation levels among industries. I don’t think John Travolta should have been paid $10M for his role in Battlefield Earth: A Saga of the Year 3000, the same year the .com bubble was bursting, but I also don’t think it’s Washington’s role to make that call.
Sen. Reid: We must put an end to the recklessness that got us into this mess.
I agree in theory, but am concerned that his definition of “recklessness” is too broad. If it incorporates all the previous concepts, including generalized greed and his notion that government should set relative compensation levels, then I’m not onboard. If “recklessness” is only excess compensation that encourages system-jeopardizing risk-taking, then I’m open to a discussion if those concepts can be precisely defined.
Sen. Reid: He supports Treasury’s rules to limit compensation for TARP recipients. He also supports the Fed’s announcement that it will rein in banks that reward the riskiest practices … gambles that endanger all of us.
I have covered these above. I am uncomfortable but can live with compensation limits for TARP recipients. I need to study how the Fed proposes to “rein in banks that reward the riskiest practices.” I am open to the concept subject to understanding and being comfortable with the details, but I hope there’s a way we can do it other than through compensation limits.
Sen. Reid: In upcoming legislation, We will make sure banks are compensating their employees in a prudent way. That means firms won’t be able to throw cash at a trader who closes a big, risky deal … one that puts the whole bank at risk and that threatens taxpayers and the greater financial system as well.
It’s interesting that he says banks here, rather than Wall Street more generally. What is the policy interest in how a small non-TARP Midwestern community bank pays its CEO? Or would Sen. Reid’s limits apply only to large banks with trading desks that pose risks to the financial system, as suggested by his second sentence? And is he concerned with compensation of all bank employees, or only of big traders?
Sen. Reid: Wall Street has to take responsibility for its own actions also. So these firms whether or not they owe the government for their survival should be careful about what their actions say about them because the American people are listening closely.
This is a bald-faced threat to all of Wall Street: firms “whether or not they owe the government for their survival should be careful” to “be careful about what their actions say about them.” This kind of vague but direct threat is highly inappropriate for a leading policymaker.
So here’s my DRAFT position:
- Government should generally not be involved in compensation decisions.
- When government has invested billions of taxpayer dollars in a firm, it is OK for government to set limits on compensation levels to protect the taxpayer. Ideally both the investment and limits are temporary.
- If it can be shown that certain compensation structures significantly exacerbate risk to the financial system, then it is OK for government to set limits on these compensation structures, but better to consider policies directed at the risky behaviors directly. Depending on the details I may be able to live with the former, but prefer the latter if possible.
I really don’t like #2, but I cannot find a principle that makes me less uncomfortable. Striking #2 would conflict with a gut common sense that taxpayer funds should not support huge compensation packages. It may be that the conflicting goals of noninterference and taxpayer protection cannot be cleanly reconciled.
A friend makes a convincing case that accounting rules and bank practices create a mismatch in which certain employees have been and are paid for shifting risks onto the taxpayer. If he’s right, then we should try to fix those mismatches directly. That’s the concept in #3. Leaving the mismatches in place and instead changing the compensation structures is a kludge.
I invite suggestions from readers for alternative positions, especially on #2. In firms in which the taxpayer has invested billions of dollars, what should be the government’s role in compensation structures and levels? (Rants and SHOUTING about greedy b******s will be ignored or deleted. I’m looking for reasoned logic, please, not table-pounding.)
I will close with a question and caution of my own for Wall Street: Why do boards structure compensation packages that appear to reward failed firm leaders with generous exit packages? I understand that some private equity firms include clawback provisions in their compensation to address this situation. Why don’t other financial firms do this?
Excepting the recent TARP situation, most policymakers I know (other than those on the far left) are quite comfortable when successful firm leaders get high financial compensation commensurate with their contribution to the firm’s success. But when they see a headline, “Fired CEO X leaves with $Y million,” it puts these elected officials in a really tough position if they are asked a question by a reporter. Yes, I understand that much of that $Y million is deferred compensation. It doesn’t have to be deferred. And when you (corporate board members) put free market officials in an indefensible position, you make it much harder for them to defend a hands-off approach to compensation policies.
A factory worker who is fired for poor performance generally doesn’t get a huge exit package. Why does the CEO?