FDIC’s Pay Caps Will Keep Businesses on “Sidelines”

At 11:30, in a much-anticipated speech at the U.S. Chamber of Commerce, President Obama used Super Bowl analogies to urge American businesses to “get off the sidelines,” “get in the game,” and “invest in America.” But some two hours later, an action by Federal Deposit Insurance Corporation proposing to slash bonuses at financial firms illustrated why so many private-sector players are reluctant to enter a “game” in which the referees change so many of the rules at mid-quarter.

The proposed rules issued by the FDIC would require banks, brokerages, and other financial firms to defer 50 percent of executives’ bonuses for three years. The FDIC, in coordination with other agencies, was given the authority to issue such a rule by Section 956 the of the 2,400-page Dodd-Frank Act that passed last year. But the law doesn’t require this action to be taken. If Obama really wanted to be true to his word about rational regulation, he would tell the FDIC — led by George W. Bush-holdover Sheila Bair — to shelve this rule that micromanages decision that should be made by private companies and their shareholders.

In a free market, it’s up to a company’s owners to decide how to reward those who run it. What is Facebook CEO Mark Zuckerberg worth given the value he has created? That is a hard question; but it is thankfully one government bureaucrats don’t have to decide. The owners of Facebook and every other companies.

The stated purpose of some of the other provisions of Dodd-Frank — such as say-on-pay and “proxy acccess” — is to give shareholders more of a say on how the amount of CEO pay and how it is structured. Whether these provisions actually do this — or whether they simply override state law and empower special interests — is another story.

But here the FDIC as nanny-state entity is overturning the entire justification of shareholder empowerment by dictating terms of a financial executives’ compensation. The argument is that pay practices can encourage “excessive risk taking,” but it simply isn’t borne out in the data that executives made the hazardous bets they did to reap short-term gains.

A study issued by the National Bureau of Economic Research (NBER) from finance professors at the Univeristy of Ohio and the Swiss Federal Institute of Technology found that “banks with higher option compensation and a larger fraction of compensation in cash bonuses for their CEOs did not perform worse during the crisis.” In fact, the study found some evidence these executive performed better than those at banks that had deferred long-term pay plans along the lines the FDIC is now proposing to mandate.

The NBER study and other evidence indicates that bank CEOs were just as caught up in the housing bubble as other players, such as home buyers, the real estate industry, and government-sponsored enterprise Fannie Mae and Freddie Mac — of which all members of the Financial Crisis Inquiry Commission agreed contributed to the crisis, but disagreed on the degree of this contribution.

Many financial executives, like the others, believed that housing would go up in the long haul and many invested accordingly. The authors of the NBER study conclude: “Bank CEOs did not reduce their holdings of shares in anticipation of the crisis or during the crisis. Consequently, they suffered extremely large wealth losses in the wake of the crisis.”

Regulations on CEO pay are a poor tool to address bank risk-taking. This should be addressed by reserve requirements, leverage rules, and above all reform of deposit insurance to reduce the moral hazard of taxpayer guarantees. The FDIC bonuses threaten to make U.S. financial firms — and the Main Street businesses who depend on financing from these firms — less competitive and put a crimp on job growth.