By Barbara-Ann Gustaferro and David B. Miller
s researchers, policy analysts and members of the banking industry continue to debate the actual extent to which bank compensation practices led to the financial crisis, federal banking regulators have moved forward with efforts to require banking organizations toreconsider and, in many cases, revise their incentive compensation pay design and practices. The push by the Fed and its counterpart financial regulators to address bank pay comes as little surprise. In early 2009, media reports of large bonuses being paid to bankers whose employers had received bailout funds under the Troubled Assets Relief Program (TARP) ignited a public furor over executive compensationat financial institutions. The Federal Reserve and its counterpart financial regulatory agencies came under a firestorm of criticism for having allowed runaway bonus structures in the financial industry to fuel heedless risk taking which ultimately resulted in the economic meltdown. Even if bank pay is found not to have played a significant role in the economic crisis, the Fed appearsBarbara-Ann Gustaferro is special counsel at, and David Miller is a partner of, Faegre & Benson LLP, where they are based in the firm’s Minneapolis office. Barbara-Ann Gustaferro focuses her practice on executive compensation and employee benefits. She has advised banking clients on compliance with the executive compensation and corporate governance standards under TARP, and has authored or co-authoredseveral articles on the regulation of executive compensation in the financial services industry. She received her degrees from Harvard Law School and the University of Notre Dame. David Miller focuses his practice on securities regulation, public companies, governance, mergers and acquisitions and venture finance. He works extensively with clients in the financial services industry, includingparticipants in TARP, and has been an active writer and speaker on the financial crisis and financial regulatory reform. He is a graduate of the University of Michigan Law School and Dartmouth College. 8 • Banking & Financial Services Policy Report
determined to avoid being accused of inaction on this subject. It is supported in its efforts by some financial economists who see increased governmentoversight of financial institution compensation as essential, pointing to certain factors that make banks particularly susceptible to imprudent risk taking1: • Because banks make money by having their deposits flow to those in need of capital—and by the same token, don’t make money if they don’t—they tend to take on a higher proportion of debt relative to their equity. Although it is normally thecase that shareholders will enjoy the upside of risk taking while debtholders will bear most of the downside, in the case of financial institutions, debtholders will be disproportionately vulnerable relative to shareholders. • Government-provided deposit insurance makes banks’ creditors less likely to demand that banks hold as much capital as they would absent such insurance. • The moral hazardof “too big to fail”: Large or sophisticated financial institutions may be particularly willing to take on dangerous levels of risk, in the hopes of bigger payoffs, because they believe that, in the worst-case scenario, the government will have no choice but to save the bank from collapse in order to avoid the greater consequential harm to the economy at large. Bankers and their shareholders standto reap the upside of risk taking, with the downside being borne by taxpayers.This creates the peculiar incentive for financial institutions deliberately to make themselves large and complex in order to assure themselves of this safety net. Well before the adoption of the Dodd-Frank Act2 in July 2010, the Fed had already launched its own initiative to require financial institutions to reexamine,...