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FDIC Advances Bonus Pay Curbs, But Execs Have a Work-Around

Here’s the thing about the FDIC: They try. Almost alone among the major regulators, they have pressed for real limits on risk-taking activities at the major banks. Since they ultimately have to spend from their budget should banks fail, they have plenty of incentive. And they have a leader in Sheila Bair who takes her regulatory commitment seriously, rather than as a service for Wall Street.

So Bair is trying again. The FDIC voted yesterday to require bigger banks to pay more into the agency fund to cover the cost of bank failures. They also proposed a three-year deferral for half of all bank bonuses for top executives at the largest financial institutions. They advanced this rule on Monday on all firms with over $50 billion in assets. It would apply to all executives who stand to cause losses in a particular company.

The problem is that the execs at the top firms have already discovered a work-around on this one. Even though many firms shifted more bonus pay into company stock to comply with the expected rules, through hedging they can eliminate the downside risk.

More than a quarter of Goldman Sachs’s partners, a highly influential group of around 475 top executives, used these hedging strategies from July 2007 through November 2010, according to a New York Times analysis of regulatory filings. The arrangements were intended to protect their personal portfolios when the firm’s stock was highly volatile, especially at the height of the crisis.

In some cases, executives saved millions of dollars by using these tactics. One prominent Goldman investment banker avoided more than $7 million in losses over a four-month period.

Such transactions are at the center of a debate over whether Wall Street executives should be allowed to hedge their stock holdings. The concern with hedging is that executives can easily break the ties between compensation and company performance. Employees who hedge their holdings are less concerned about a falling share price. That’s why the government barred top executives at banks that received multiple bailouts from using the strategies until they paid back the funds.

What this comes down to is that financial executives do not want to be paid for performance. They want to be paid. And so they will construct any number of ways to ensure the money keeps flowing their way, even if their recklessness leads to a downturn for their company.

With this news about hedging out, FDIC has considered banning the practice.

The concern is executives could use hedging techniques to make up for losses if their company’s stock goes down during the deferral period, which could put executives’ interests at odds with those of shareholders.

“Whether we should be prohibiting hedging in this, that is an issue that is left open,” FDIC Chairman Sheila Bair said.

The FDIC proposals do not go as far as rules in the European Union, particularly in Britain. Most financial executives there can only receive 20% of their bonuses in immediate cash. If only the FDIC was involved in this decision, maybe we would get to that point. As it is, the Federal Reserve, the Treasury Department and the SEC have to weigh in.

The larger problem is that the banks have far too much control over the whole of the federal government to ever have rules like this stick. They can threaten to move operations or fail to lend out to the economy, and those threats get seen as credible, despite the obvious issues (is there some other country with the proper tools for the financial industry not experiencing some form of fiscal strife right now?). If anything, we could see an influx of banks coming to the US, since our political system isn’t mature enough to resist their influence.

New York-based banks might move to London, and vice versa. But the Bank of England is far ahead of the Federal Reserve in its thinking about how to rein in banks – see, for example, the new paper by David Miles (a member of the Monetary Policy Committee in Britain) on the need for much more equity financing in banks than specified in the Basel III agreement.

Officials outside the United States are increasingly beginning to understand the point being made by Anat Admati and her colleagues – bank capital is not expensive in any social sense (for example, look at Switzerland, where the biggest banks are now required to have about double the Basel III levels of equity funding). The United States needs its financial system, particularly its largest banks, to be financed much more with equity than is currently the case.

The intellectual right in the United States understands all this and, broadly speaking, agrees. Officials in other countries begin to see the light. Unfortunately, officials in the United States and those of the political right who seek public office – as well as much of the political left – still appear greatly in thrall to the big banks.

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David Dayen

David Dayen