Unfinished business: Banker pay reform

When Federal Reserve Chair Janet Yellen delivers her semi-annual report on her agency to Senate and House banking committees on July 15 and 16 respectively, she should face questions about what President Obama recently called the “unfinished business” of Wall Street reform: banker compensation.

Bankers didn’t crash the economy for amusement (we hope). Their reckless and often fraudulent actions resulted in part from compensation structures. Loan originators falsified mortgage documents to maximize commissions. Mortgage securitizers gutted quality control reviews to meet pay-connected approval quotas. Traders doubled down on high-risk positions for higher bonuses. And senior executives disguised their precarious dependence on overnight loans until they could cash in on their stock options.

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Following numerous investigations highlighting the role of Wall Street pay in the crash, including a high-profile investigation by the Financial Crisis Inquiry Commission, Congress adopted Section 956 of the Dodd-Frank Wall Street Reform Act. This provision directs the regulators to prohibit pay structure that “encourages inappropriate risks.”

Given the central role of pay in the crisis, Congress set an urgent deadline for regulators to prescribe a rule: April, 2011. That’s more than three years ago, and while a proposed rule came out fairly quickly, it was weak, and we’ve seen no signs that the final rule is near.

On July 3 of this year, President Obama declared the need for independence from Wall Street gambling. He called for banks to grow the “real economy. . . not a situation in which we continue to see a lot of these banks take big risks because the profit incentive and the bonus incentive is there for them. That is an unfinished piece of business.”

To her credit, Fed Chair Yellen has placed this rule on its agenda of priorities. So have all the other agencies that must jointly write the rule, with one notable exception: The Securities and Exchange Commission.  Public Citizen recently documented the unusually slow pace of rule-making at the SEC, noting that Chair White has moved back most of the deadlines she originally set six months into her tenure. We urge her to hasten the pace on this rule and other pressing reform needs.

But next to Obama, Yellen is the nation’s most important financial policymaker. The rule that the Fed and other regulators proposed in 2011 is woefully inadequate. It proposes no substantive changes, requiring only that banks adopt vague guidelines. It requires that a fraction of pay be deferred for three years, but most major banks have already adopted stronger deferral policies.

One idea addressed by Fed Gov. Daniel Tarullo along with New York Federal Reserve President William Dudley calls for linking banker pay to the bank’s debt. While stock options link pay to a rising stock price that might follow added risk, debt would link pay to the bank’s reduction in risk. If the bank faltered, this debt would be converted to equity. That means the banker would sacrifice interest payments and the claim on debt repayment. Instead, the banker would hold equity presumably priced at market value substantially less than the debt.  What is  Yellen’s view of this idea? 

More broadly, we urge the Fed to replace a bonus system that draws away some of the brightest young minds who might otherwise work in technology or pharmaceutical industries.

Can reforming banker pay address the yawning income gap? The concentration of wealth in the top centile is no better expressed than with excessive banker compensation. As part of the Fed’s mandate to maximize employment, this concentration of corporate revenue in pay for the elite leave less for rank and file workers, less money to expand overall employment.

With this statute, the Fed and other regulators can establish rules that will restore sanity to banking, returning it to its mission of sober intermediation between savers and users of capital. It’s time to finish this business.

Naylor is a financial policy advocate for the Congress Watch project at Public Citizen, a consumer rights advocacy group.