What if We Paid Bank Regulators for Performance?

Well then they probably wouldn’t make much money would they? Zing! No but seriously. 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 doubt 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.

The authors are essentially proposing giving regulators stakes in the banks they oversee, by tying their bonuses to the changing value of the banks’ securities, theoretically giving them a motive to intervene when things look dicey. If the incentives are well designed, the authors argue, regulators would capture the benefits that accrue from making banks more valuable, and suffer the negative consequences when banks fail.

(iStockphoto)

The proposal would completely change the role of the regulator, from antagonist to partner. The authors think this would lead regulators to use private information they learn on the job, not only to improve their own 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.

At scores of banks, examiners and other regulators were well aware of operational deficiencies and excessive risk taking several years before those banks failed. But regulators stood still in the face of this information. They utterly failed to demand corrective action by banks. Instead, examiners continued to rate these risky institutions as “fundamentally sound.” Washington Mutual, the largest bank failure in U.S. history at the time of its failure, enjoyed a “fundamentally sound” rating until six days before its collapse. Defending regulators’ existing incentive structure seems quite problematic after the Crisis.

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  1. Caleb b says:

    By the time a regulator thinks there is a problem, it is way too late. This has been true throughout the history of banking.

    Wanna know who becomes regulators? Kids out of college with zero work experience, and people that got laid off from banking jobs.

    “a bank regulator is a guy born without a nose trying to figure out who farted”

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  2. Dave says:

    This could be a great idea, but I wouldn’t be surprised that — if implemented — it led to some cases of regulators actively helping bankers cover up fraudulent activities.

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  3. Joshua Northey says:

    Presumably every type of pay should be “for performance” shouldn’t it? What else would it be for?

    Settling on the definition of “performance” and determining the linkages/measurements that indicate it is where the real rub is. What kind of job doesn’t pay for “performance”?

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  4. M.M. says:

    Why aren’t bank regulators simply law enforcement, even if by another name? Do detectives get into their line of work for the pay? Do prosecuting attorneys? These are people that (a) get satisfaction out of catching wrongdoers and unraveling their schemes and/or (b) see high-profile collars/convictions as a means for political advancement. I don’t see why we aren’t courting the same kind of people, giving them the same kind of enforcement authority, and treating the banks and financial houses as adversaries, rather than chums.

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  5. Roy says:

    It has negative value to the degree it distracts from the need to fix Too Big To Fail.

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  6. Caleb b says:

    Regulators can make sure that any one bank is not over betting on any one asset class, but they can’t do JACK SQUAT to prevent every bank from betting on the same asset class.

    See Georgia and Construction & Real Estate Development.

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  7. steve says:

    LOL, the answer to market failures is more government regulation. The answer to failures in regulation is to attempt to mimic the market.

    In practice, banks will fail. All types of businesses can and do fail. Banks are no exception. One of the perverse consequences of regulation and central banking is to simply insure that banks fail in unison since they are all assesing risk in the same fashion just like the regulators tell them.

    There are no regulatory rules that can adequately asses risk. Risk is devilishly hard to evaluate. Primarily, because it changes based upon what other people do. If many people believe a particular asset class is low risk and park their money there the risk of investing in that asset class increases. There is no asset class that cannot experience sharp drops in value. Even the dollar itself is not immune. Therefore, there is no single asset class that a bank can hold as a reserve that will not at some point in time result in insolvency. Risk is dynamic.

    Regulation treats risk as static. This is a mistake. Furthermore, even if the regulations were dynamic, requiring all banks to behave in the same way with regards to what assets are and are not risky in itself increases the risk.

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  8. Daniel says:

    What if the poor bank regulatory outcomes stem from insufficient resources? What if bank regulators cannot regulate effectively because they don’t have the necessary access to information, don’t have enough time/man-power or don’t have the requisite knowledge and skill set? This incentive structure, which ties regulator compensation to (hopefully, long run) bank performance may encourage qualified and unqualified regulators alike to look for other less-risky jobs. If you, as a regulator, do not feel you have the power necessary to maintain the financial security of a bank, why would you ever agree to such a compensation arrangement?

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