Assessment of US Financial Sector Compensation: Why Is Reform Needed? What Might Be the Reasons That US Reform under Dodd-Frank Failed? What Can Be Done Going Forward?

Abstract

A Google search of “bankers’ pay and financial crisis” brings up a few hundred millions hits. This fact reflects public sentiment about the role of incentives and the importance of controlling incentives in financial stability. Although the adverse effect of incentives on the heath of the financial sector has been recognized by bank regulators, they have failed to advance the agenda on bankers’ pay reform. Regulators have secured more resources from bank owners, who have little influence over bank governance, to ensure that banks can absorb potential shocks. Yet, they have made little progress in controlling the incentives of bank employees, the risk takers, who could inflict large damage on financial stability, as happened during the 2007–2009 financial crisis. This essay provides an overview of the history of the regulatory sector’s efforts to identify effective ways to compensate bankers as a means to motivate them to serve the public interest. It is an attempt to shed light on how political constraints affect the implementation of policies. The evidence collectively supports the argument that US regulators were reluctant to reform bankers’ pay because they did not understand its objective or its importance and they failed to establish a sound governance process to assess the importance of compensation and arrive at a prudent solution. Organizational (task) failures are not unique to the private sector, but failures are less obvious at the Federal Reserve System, an opaque institution similar to the entities that it supervises, the banks. The essay also explores potential sources of failures and discusses as to why it is important to identify and write about the weak spots in public policy tasks in the System and potentially improve its functioning.

Keywords: Dodd-Frank Reform Act, Compensation reform, Financial institutions, Incentives, Risk taking, Debt-like pay, Funded deferred pay, and Performance bonds