Despite the fact that all the big banks have paid back their bailout, many policymakers are still concerned about outlandish banker compensation. One interesting suggestion has been made by the Federal Deposit Insurance Corporation. Maybe if it deems a bank's compensation scheme as too risky, i.e. giving employees too much earnings and not holding onto enough earnings to use as cushion for unforeseen disasters, then it could charge the bank more for its depository insurance. It will vote on the plan next week. While clever, I still think stricter leverage and capital requirements are a better way to deal with bank risk and compensation.
I read about this suggestion in an article from Breakingviews.com. It explains the rationale:
Generating the most buzz is a sensible plan to tie the amount that banks pay for deposit insurance to the risk in their compensation plans. Banks with plans that favor short-term gains would pay more than those that, for example, include multiyear clawbacks on bonuses.
That could work. But I worry that this slick plan kind of misses the real problem: actually preventing banks from running out of cash in the first place.
As I've said before, regulators would be better off focusing on more prudent leverage and capital requirements for banks. That way, the probability that banks would get into trouble in the first place would be lower. This would also cover investment banks, which the FDIC plan wouldn't, since they don't have deposit insurance.
And as I've also mentioned before, more conservative capital and leverage requirements would also limit compensation by their very nature. One of the reasons why investment banks are able to make so much money is because they have so much leverage. For example, if you can make $5 profit by only holding $10 of capital, that's a 50% return. If you need to hold $20 of capital, then your return is only 25%. As a result, bank employees will be forced to make less money, since more of its revenue must go towards its capital base as its assets increase.
So I think the compensation problem will take care of itself if leverage and capital requirements are reformed. Then you don't have to worry about any tricky regulatory measures to control how compensation is paid by charging more for deposit insurance. I favor ensuring we have more stable financial institutions that consequently can't help but have more down-to-earth pay scales, rather than attempting to back into stability by forcing banks' hands through dictating how they should compensate their employees.