Saturday, February 12, 2011

U.S. Regulators Toughen Rules on Bonuses at Large Financial Firms


This past Monday, the Board of the Federal Deposit Insurance Corporation (the “FDIC”) approved a new draft rule applying to U.S. financial institutions holding more than $50 billion in assets. The rule requires banks to withhold at least half of their top executives’ bonuses for three years or more. This bonus deferral rule is designed to align executive compensation with the long-term effects of the executives’ decisions. The rule would also require banks to identify lower-ranking employees making risky investments and tailor their individual bonus plans so as to discourage them from excessive risk-taking.

The draft rule met considerable criticism, however. Its opponents are concerned that it represents a uniform and inflexible approach to revising bonus pay. For that reason, the rule’s disadvantages may, at least in some instances, outweigh its utility. Some critics go even further by claiming that the deferral rule is unnecessary because banks have already taken steps to align employee compensation with financial institutions’ long-term well-being. Yet another line of criticism maintains that government-imposed restrictions on compensation will cause U.S. firms to lose their best employees to foreign competitors with less restrictive pay practices.

The rule’s proponents respond that although the draft bonus rule brings U.S. pay practices closer in line with international standards, the rule nevertheless establishes a much less restrictive regime. Thus, proponents argue that any fears of losing highly qualified employees to foreign competitors are unfounded. Among the rule’s proponents is FDIC Chairman Sheila Bair. She is confident that the bonus deferral rule is the remedy for those poorly designed pay policies incentivizing excessive risk-taking within financial institutions. Some commentators have argued that rewarding short-term investment returns without any regard for the investments’ long-term risks was one of the causes for the most recent financial crisis. Eliminating such misalignment between compensation and long-term risk is precisely the rule’s purpose.

Of course, the draft rule is not in force yet. Having been approved by the FDIC’s Board, the draft rule will now be submitted for approval by six other government agencies, including the Securities and Exchange Commission and the Federal Reserve Board. Once approved by them, the rule will be issued for public comment. After the comment period has run, the final version of the rule must be voted on by all seven government agencies involved. Despite these forthcoming stages in the rule-making process, FDIC Chairman Blair does not believe that the draft bonus rule will undergo any substantive change.

Discussion Questions:
1. A major motivation behind adopting the bonus deferral rule is that flawed pay practices at large U.S. financial institutions played a role in bringing about the most recent financial crisis. Many critics, however, dispute the relationship between the compensation practices and the financial crisis. Since the relationship between the two has not been definitively established, is the bonus deferral rule necessary at all?
2. Some have called the draft bonus rule a “one-size-fits-all approach.” Should the draft rule be revised to allow financial institutions some flexibility in designing their own pay practices?

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