Wall Street Pay Curbs Are Naive and Unnecessary
Last week it was announced that the Federal Reserve would move forward on its plan to police and restrict pay among employees of large financial institutions. At first blush it's hard not to be just a little bit sympathetic toward these efforts.
Indeed, while the symbol that is Wall Street talks a good game about markets and capitalism, many firms were more than eager to take bailout money, not to mention willing to change their regulatory status to that of bank holding companies in order to access taxpayer subsidized cash during a time of need. All that, plus during the crisis period of a year ago, rather than ask for less help and less regulation from Washington, financial institutions lobbied for a suspension of mark-to-market accounting in concert with curbs on short selling. "Capitalistic" does not describe Wall Street.
Still, the suggested new rules on what the media term "banker pay" should not go through. They shouldn't because they won't work.
The Fed would like to create a compensation structure that aligns the interests of financial employees with the long-term health of the firms they work for. There's nothing wrong with that on its face, but as evidenced by the massive financial hits taken by the former employees of Lehman Brothers and Bear Stearns through their stockholdings in both firms, incentives were already aligned.
Some say Wall Street firms should return to the "partnership" structures of the past, but once again, Wall Street employees were and continue to be major partners when it comes to company success and failure. The large annual bonuses that offend so many were frequently equity based, so this notion of trader profligacy with the money of others never made a lot of sense.
It also has to be remembered that the individuals who staff financial firms are its assets. Assuming the imposition of pay restrictions that outwardly have teeth, it's a certainty that the sharp minds who oversee compensation within financial firms will quickly figure out ways around any new rules. They will because absent an ability to pay market rates for talent, they'll soon prove irrelevant and probably not worth regulating.
Of course, if it turns out that the pay curbs prove insurmountable, market forces will once again work their magic in ways that regulators won't like. Just last week the Financial Times reported that thirty SocGen executives were leaving the French bank to start a new hedge fund with backing from a U.S.-based private equity firm. As the FT put it, "the bankers decided to leave amid growing pressure on French banks to cut executive bonuses."
Much the same will occur among U.S. financial firms. If the talent within feels it's not being properly rewarded amid new restrictions, there will be smaller firms deemed not important enough to merit substantial oversight eager to enhance their collection of quality financial minds. What the media and regulators term "systemic risk" will simply find a new, unregulated address.
And if the Fed's tentacles somehow reach to the smaller financial institutions and large hedge funds previously in operation without much oversight, the attempt to impose curbs on pay will still fail impressively. That is so because what we call finance is extremely fungible.
Indeed, what's consistently ignored by our federal minders is that the dollar is the same in London and Tokyo as it is in the United States. If pay restrictions become too onerous, it won't take the industry that is finance long to shift its operations to overseas markets not regulated by U.S.-based bureaucrats.
Along those lines, back in the late ‘70s and ‘80s capital controls and rate regulations were foisted on the banks. But with the Eurodollar market nothing if not sophisticated, U.S. banks were able to take in dollars from unregulated foreign affiliates and foreign banks in possession of same. Sarbanes-Oxley made it difficult for U.S. firms to float their shares on U.S. exchanges, but far from keeping them from going public, they've simply listed their shares on foreign exchanges.
In short, if rules with regard to pay actually work this time, they'll only work insofar as the symbol that is Wall Street will move overseas. Taxable profits that politicians enjoy spending (all the while bashing the industries that produce them - think tobacco) will easily move elsewhere to be wasted by foreign politicians.
One Fed suggestion on pay is that it shouldn't so much be restricted, as there should exist "clawback" rules on bonuses. By this the Fed will reserve itself the right to demand that banks take back bonuses paid on transactions and deals that later prove unprofitable. A nice thought that one is, but it's also terribly naïve. It is because as anyone who's worked on Wall Street knows well, the reason the pay is so high has to do with the fact that those whose transactions are unprofitable find themselves out of work with lightning speed. In that sense, finance professionals are already in possession of strong incentives to do well for themselves by doing well for their firms and the firm's shareholders.
Amid all the hysteria over pay, what's not been discussed enough is the basic truth that without capital, there are no salaries and bonuses. Put simply, investors who provide the capital to financial firms have strong and more knowledgeable incentives to make sure that pay correlates with the long-term health of the companies they own. In that sense, what's needed is not more rules, but rather a clear signal that failures and successes will be solely owned by shareholders as opposed to taxpayers.
The above is a costless way of fixing that which regulators deem problematic, but that they are unsuited to oversee absent myriad unintended consequences. Of course a rule like this would render regulators irrelevant, which means it's pure fantasy to assume that something which would actually work will be implemented. Instead, the Fed will attempt to control compensation with Washington's blessing, and it will fail miserably.