Bank Pay Regulations Miss the Point of Financial Reform

As talk of finance reform continues in the wake of this summer’s Dodd-Frank bill, the baleful eye of federal regulators has once again fallen on financial services execs and their filthy, ill-gotten lucre. From The WSJ:

U.S. regulators are considering whether to require large financial firms to hold onto a chunk of executive pay to discourage the excessive risk-taking that contributed to the financial crisis, according to people familiar with the situation.

Giant companies such as Bank of America Corp., J.P. Morgan Chase & Co., Goldman Sachs Group Inc. and Morgan Stanley that are considered critical to the U.S. economy, could be forced to award half or more of their executives’ pay in the form stock or other deferred compensation, instead of up-front cash.

Whether such a policy could reduce systemic risk can be debated, but it does nothing to deal with one of the main drivers of market instability: the bailout mentality of “too big to fail” (TBTF). As Anthony Randazzo has argued, if that doctrine could be (credibly) abandoned, firms that overrewarded risk would either learn the error of their ways or perish with no cost to the taxpayer. It’s difficult to see how any government management of pay schemes will solve the problem of excessive risk-taking without addressing the moral hazard of TBTF.

There are two possible scenarios here here: either the too-big-to-fail mentality persists, encouraging financial institutions to find creative ways to stuff their execs’ pockets with cash for making risky bets, or it disappears, putting downward pressure on executive payouts. It’s vital, in any conversation of new regulations, that this point is not forgotten.