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.


YX

Pay for performance also pay for cheating. And cheating by regulators would suck mightily.

pshrnk

That is the point....to align the regulators self interest with appropriate regulation. Must set a long time frame to prevent short term cheating.

Tg3

Wouldn't the problem be easier solved if executive and investment banking bonus were tied to a long time frame to prevent long term cheating/gaming?

Zach Brannan

It seems flawed to think that placing the regulators' interests in line with the shareholders will benefit the economy. More likely it will benefit the banking industry. Why not get a cross section of Banking CEO's to regulate the banking industry - they likely already have compensation tied directly to the performance of their banks. Regulations should protect the economy as a whole. It'd be too easy to get compensated for several years of a false run-up of the banking industry, retire and then let a shill take the brunt of the collapse.

Eric M. Jones.

Why do I get the feeling that they will game the system anyway...?

juan camaney

regulators should not exist at all, they go against the principles of free market, if they exist so we should have regulators in all industries? they would send the right signals to investors about bad markets right? should we have also a goverment regulators? they would send the right signals to voters about how crap is the current goverment lets say in the uk???

Derek Fields

The ultra-libertarian notion that regulators go against the principles of the free market is ludicrous. Markets are neither perfect nor universal. Because they are not perfect, regulators serve to ensure that the more powerful in the relationship can 't abuse that power at the expense of the less power. That is why insider trading, for example, is regulated - those with access to inside information have more power (information) than other investors. Without regulations to block the use of that information, the market is skewed. Likewise, markets don't naturally reflect social imperatives such as clean air or safe pharmaceuticals. Allowing people to die isn't an ethical corrective on market behavior.

Mike B

When Bank Regulators are overseen by an administration and a congress that doesn't believe in regulation then "performance" means doing exactly what they did.

Derek Fields

Economists are over-reliant on financial incentives as if human behavior is entirely represented by monetary reward. But we know that is wrong. While financial remuneration is important, workers frequently trade salary and bonuses for other less tangible benefits, primarily job satisfaction. Regulators are no different; they are more likely to do their job well when they believe that their work is valued. However, our ambivalence towards regulation (see the comments on this blog for example) leads to a lack of respect and relatively low job performance. When the people who respect you most are the people you regulate, you tend to favor their good outcomes over outcomes that benefit people who don't know, don't care or don't value your work.

Generally, we treat regulators as an impediment until they fail to prevent the very behavior they are intended to regulate. If we want to find a financial incentive to make regulators work harder to uncover potential wrongdoing, we would be better served to give them a commission based on how many fines are levied against the firms that they regulate.

Regulation need not be adversarial; at its best, it creates a level playing field that enables the market to work properly to produce an efficient mix of goods, prices and outcomes (some of which are ancillary to the market, such as safety). However, regulators should be adversarial, assuming that the market participants that they regulate will try to cheat the system whenever and however they can - hence the reason for regulation and regulators. The incentive for regulators should reinforce and strengthen that adversarial relationship, not weaken it by making them partners in the very firms that they regulate.

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Roger S

We don't pay bankers for performance because it cannot be objectively measured. The pinnacle of regulatory performance is when no bad things happen ON YOUR WATCH. Now, the absence of bad headlines has two causes:

1. Either regulation's working, and bad things aren't happening, or
2. Bad things are happening, but the news is suppressed until after your watch.

It's impossible. You can't prove a negative, and you can't exactly clawback bonuses from incompetent regulators who pushed the bomb into another time zone. For the sake of argument, let's assume we're going to regulate them. How much should we pay? Payment is a function of

1. Regulatory benefit to mitigating damage, and
2. Original magnitude of the possible damage.

Needless to say, both figures are speculatory and easily manipulated.

David S

Roger and Derek
I agree with much of what you both say, but I don't think the challenge of incentivising regulators by rewarding them for the lack of failures on or after their watch is insurmountable, particularly if one bears in mind the tendency for senior regulators to be recruited from the industries they are being asked to regulate, rather than being career regulators with a different public service ethos.
Once could start by establishing a very substantial contractual bonus pot for each year of responsibility and at the end defer payment for 5 years after leaving post. The pot would be depleted in the event of any corporate failure in the sector for which the individual was responsible, with the amount of depletion a function of the size of the losses, with an additional penalty in the event of a bail-out using public money. This would encourage a regulatory culture based on risk mitigation rather than box-ticking and back-covering; at the same time the regulators would have to be given pretty broad scope to intervene in cases where the corporate culture was irresposible, whether or not specific rules had been broken.

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Jake

What's the definition of excessive risks? Most of the failed banks were in the mortgage business and they were meeting the standards need for selling the loans to Fanny or Freddie. Those standards were wrong which the regulators do not any control over.

Have these lawyers ever worked on the bank audit? I worked on the banking side and the auditors were always overwhelmed by the amount of data & complexity involved in large banking operations. Adding some incentives will not change that situation.

Caleb b

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"

Dave

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.

Joshua Northey

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"?

M.M.

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.

Roy

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

Caleb b

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.

steve

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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