They’re coming for your bonus

 

 

 

By Peter J. Wallison.

 

 

 

America’s economic recovery since the recession ended in 2009 has been the weakest in decades, principally because the 2010 Dodd-Frank financial law suppresses risk-taking. Now another Dodd-Frank rule—proposed restrictions on incentive pay in the financial industry—could be the coup de grace for U.S. growth.

The proposed restrictions have been agreed to by the six major financial regulatory agencies, including the Securities and Exchange Commission and the Federal Reserve, and would apply to thousands of executives and traders in the largest banks, asset managers, broker-dealers and others.

The new rules impose limits on incentive pay such as bonuses, and require that 60% of any incentive compensation be deferred for at least four years. Bonuses would also be subject to “claw back” by financial firms for up to seven years after being paid in the event of losses attributable to poor judgment or undue risk-taking by the recipient.

The best way to understand the effect of these proposals is to consider them in the context of the legal principle known as the “business judgment rule.” This rule holds that corporate boards of directors cannot be sued for a decision made with the best information available and in the good-faith belief that it was in the best interests of the corporation.

 

This is a judge-made rule long embodied in the common law and upheld by courts over many years. The underlying policy for the rule is clear: If directors are liable for suit any time they approve a corporate action, it will be difficult to get them to approve anything, and corporate risk-taking—as in mergers or other major transactions—will grind to a halt. To gain the protection of the rule, boards go to extraordinary lengths to be sure their decisions are adequately documented with approvals by independent experts.

The financial compensation rules now under consideration raise the same questions about risk-taking. For example, assume a bank officer is presented with a company’s application for a substantial loan for the construction of a new plant. The corporation is solvent, but the plant will be making a product that hasn’t been tested in the market. If the plant is built but the product fails to make the grade with consumers, the company could be in financial jeopardy.

Many considerations go into the bank officer’s decision, including the interest rate on the loan, the value of the collateral, the management skills and likely tenure of the firm’s CEO, and the possibility of a long-term relationship between the bank and a successful customer. Can the bank officer adequately document these known unknowns to defend himself if the loan goes sour?

Of course not. But if the proposed new rule is implemented, the officer has a personal incentive not to take the risk. It isn’t just the bank’s financial health but also the bank officer’s—the contemplated new house, the kids’ college tuition—on the line. The bank officer may choose to put his own financial well-being above his customer’s, resulting in far more loans being turned down.

 

Now imagine this scenario playing out thousands of times across the country every day for years. You can easily see that this will result in less financial risk-taking and significant limits on available credit. That means less growth and innovation for the U.S. economy, with fewer jobs and lower compensation.

How did we get here? The answer is the widely adopted explanation for the 2008 financial crisis. Although there is a great deal of evidence that the government’s housing policies were at the root of the crisis, the 2008 subprime mortgage meltdown and ensuing recession were blamed on “excessive risk-taking” on Wall Street. This gave rise to Dodd-Frank and the notion—popular among academics and regulators—that compensation in American finance had contributed to the problem.

This is a barely plausible explanation for a phenomenon as widespread as the massive housing bubble that developed between 1997 and 2007, and fails to account for the deterioration of mortgage underwriting standards throughout the U.S. after Fannie Mae and Freddie Mac were subjected to the Department of Housing and Urban Development’s “affordable housing” goals. These initially required a 30% quota of loans that Fannie and Freddie acquired to come from borrowers who were at or below the median income where they lived. That quota eventually rose to 56%, forced a deterioration in underwriting standards, and precipitated the subprime fiasco.

These new rules are based on the same false idea about the causes of the financial crisis that underlies Dodd-Frank, a law that has discouraged credit expansion and resulted in the 2% growth rate of the past seven years. We should not double down on that mistake by further sapping the risk-taking that drives economic growth.

 

More than the financial industry should be protesting these regulations. Congress should insist that the consequences for future economic growth be fully explored before the rules are allowed to go into effect.

 

What Next?

Recent Articles