Bonuses: Incentives influence behaviour. So bank examiners should scrutinize pay practices as they consider banks' safety and soundness. Making this focus clear has benefits too. It may encourage banks to restrain themselves, and it gives examiners clout if they don't.
The US Federal Reserve is considering giving regulators more sway over pay than some observers had expected, according to the Wall Street Journal, including the power to reject pay packages they believe create outsized risk. It's not logical or even prudent for regulators to set dollar limits on pay. But taking an interest in how big payouts are structured makes sense.
Flawed compensation policies contributed to problems at many financial institutions in the recent crisis. Mortgage officers were paid to originate dubious loans. Bankers were paid to create overcomplicated structured investment vehicles from questionable collateral. When traders were rewarded solely on short-term performance, those who ignored big risks could pad their pockets at their employer's expense, leaving taxpayers to pick up the pieces when bets later went bad.
Maybe the more effective watchdogs already had half an eye on compensation. But making it a defined and important focus of regulation has at least two benefits.
First, it encourages banks to restrain their own practices. If a company knows watchdogs will home in on high pay, particularly when associated with structures that don't take longer-term risks into account, then bosses might rein in bonuses rather than risk regulatory disapproval. This is likely to speed the adoption of better structures, such as spreading big payouts over several years and incorporating clawbacks if bets turn sour. It's even possible that regulatory scrutiny at the most systemically important institutions might lead them to cut pay overall and reduce risky activities, forcing the associated employees to look for greener pastures at less heavily regulated firms that aren't too big to fail.
Second, if regulators are charged specifically with looking at compensation, it will be a lot more difficult for institutions to tell them it's none of their business, as they probably have in the past. Yes, the examiners' interest should be in structure, not amount, of pay. With that caveat, the Fed should go along with its European counterparts and add compensation to its checklist.
