Pay for Regulator Performance

Few doubt that executive compensation arrangements encouraged the excessive risk taking by banks that led to the recent Financial Crisis. Accordingly, academics and lawmakers have called for the reform of banker pay practices. In our paper, Pay for Regulator Performance, forthcoming in the Southern California Law Review, we argue that regulator pay is to blame as well, and that fixing it may be easier and more effective than reforming banker pay. Regulatory failures during the Financial Crisis resulted at least in part from a lack of sufficient incentives for examiners to act aggressively to prevent excessive risk. Bank regulators are rarely paid for performance. They are paid a fixed salary that does not depend on whether their actions improve banks’ performance, protect banks from failure, or increase social welfare.

We propose instead that regulators, specifically bank examiners, be compensated with a debt-heavy mix of phantom bank equity and debt, as well as a separate bonus linked to the timing of the decision to shut down a bank. [1] Giving examiners a stake in bank performance, both upside and downside, will improve their incentives to act in the public interest. A pay-for-performance culture will work better for bank examiners than other bureaucrats because of the objective metrics (i.e., stock and debt prices) available that directly track social welfare outcomes. We do not discount the value of public spiritedness as an inducement toward good regulatory performance.  We also believe, however, that monetary incentives tied objectively to socially desirable outcomes could improve examiner incentives, especially given the failure of existing inducements in the run-up to the Financial Crisis.

The regulatory laxity preceding the Crisis involved two distinct types of regulatory failure—the failure to apply preventive medicine when times were good and the failure to act aggressively when a bank showed signs of distress. Our incentive pay proposal has two distinct components address these separate problems.

First, the bank debt-equity portfolio would offer real time market feedback and long-run incentives to the examiner regarding the bank’s risk taking and its potential rewards. We consider two potential debt benchmarks: (i) a subordinated debt security issued by the bank and (ii) a credit default swap contract (CDS) referencing a junior debt obligation of the bank holding company parent of the regulated bank (BHC). The prices of publicly traded subordinated debt securities and CDS contracts reflect the market’s best estimate of the risk of the bank’s default on its debt. Holding this risk-sensitive instrument gives the examiner a personal financial incentive to curb excessive risk at the bank. Some amount of BHC equity should be included as well in order to guard against undue examiner risk aversion. With both the debt and equity components, we suggest a relative performance approach, which would filter out the effect of industry-wide or market-wide price movements. As noted, the lion’s share of this “preventive medicine” component of incentive pay should be debt-based.

To encourage a medium- to long-term regulatory perspective, each periodic phantom debt-equity allocation would have a medium to long-term maturity, with gains or losses realized upon maturity. With regular periodic allocations, the examiner would hold multiple tranches of phantom securities with staggered maturities, giving the examiner incentive to consider the long-term as well as short-term consequences of her regulatory decisions, and making short-term manipulations of securities prices an unattractive strategy. This component would matter primarily during good times, while the bank is operating in the ordinary course. Its purpose is to incentivize preventive and remedial measures well before a bank approaches distress.

Our second component, the shutdown bonus, becomes important as a bank approaches distress. The examiner would be eligible for a cash bonus based on the timing of her decision to shut down a failing bank. Regulators have a number of reasons to wait too long before shutting down a failing bank. The shutdown bonus would ameliorate this problem. Bank regulators are by statute tasked with the specific goal of minimizing losses to the Deposit Insurance Fund (DIF). The shutdown bonus could therefore be tied specifically to the ultimate losses sustained by the DIF at the resolution of the FDIC’s receivership proceeding.  We suggest several approaches to estimating these losses ex ante in order to incentivize improved timing of bank shutdown decisions.

The full paper is available for download here.

Endnotes

[1] For each of the largest banks, one or more permanent examiners are assigned to supervise the bank as their full-time job. They have offices and support staff at the bank, and they spend a good part of their working lives as a regular presence at the bank they supervise. This permanent examiner and the large bank she supervises are our focus.
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