Posted by Shyam Moondra
Last week, the Federal Reserve Board disclosed that it is reviewing the compensation practices of the financial sector for the CEOs, traders, and loan officers. It's a well known fact that top-notch traders and loan officers can walk away with tens of millions of dollars in performance-based compensation that invariably leads to excessive risk taking. The housing bubble of 2007 was partly created by mortgage loan officers, who routinely approved mortgage applications of credit-unworthy home buyers; the more mortgages they sold, the more money they made. The investment bank Lehman Brothers collapsed because their traders took excessive risks in trading mortgage-based securities that led to crushing losses. Many of the investment banks and hedge funds were leveraging themselves by as much as 40:1, creating the potential for severe consequences if their bets didn't go their way. The failure of Lehman Brothers and the possible failure of another financial giant AIG forced the federal government to risk taxpayer's money by aggressively infusing liquidity into the largest financial institutions to avoid a catastrophic systemic failure of the entire financial system.
The aggressive actions taken by the Congress and regulators helped avoid a massive failure of the credit markets, although they couldn't save the economy from slipping into the most severe recession since the depression of the 1930's. Now that credit markets are steadily coming to normalcy and economy is gradually recovering, the question everybody is asking is could this happen again. President Obama has made it clear that if financial institutions take extreme risks and get in big trouble again, the government will not bail them out, even if they are too big to fail.
The former Fed Chairman, Alan Greenspan, said that unless a way can be found to change human nature (about greed), another financial crisis is inevitable. The root of the problem is the present compensation system, which rewards excessive risk taking exorbitantly. Some of the top-performing traders are known to have earned hundreds of millions of dollars a year. Recently, the Citigroup CEO Vikram Pandit disclosed that Citi's top trader would earn $100 millions this year and he admitted that that kind of compensation is excessive. In fact, the largest five financial institutions have put aside $50 billions for bonuses this year.
One of the easiest ways to bring discipline and sanity in compensation practices of the financial sector would be to impose caps on the compensation of the CEOs, traders, and loan officers. However, Republicans and conservative Democrats vehemently oppose such caps because that would amount to direct government interference in the free-market capitalist system.
Here are a few things that Congress and regulators could do:
· All financial institutions with assets of more than $1 billion must not be allowed to have a leverage of more than 4:1. The capital ratios of the financial institutions must be closely monitored and enforced by the regulators.
· In the second quarter of 2009, Goldman Sachs reported unexpectedly large profits; however, a big chunk of those profits came from trading in stocks, bonds, and commodities and not from traditional investment banking functions (such as mergers and acquisitions, IPOs, etc). These trading profits don't directly contribute anything positive to the economy. Big players manipulate markets, cause market volatility, and make money at the expense of less sophisticated small investors. It's time the Congress put restrictions on computerized day trading by large financial institutions. Specific restrictions could include: limiting short sales in a company's stock to 1% of its outstanding shares, banning naked short selling, reinstituting the "up-tick" rule for short selling, limiting how much trading they can do in derivatives (e.g., stock options), requiring the financial institutions to hold the stocks they buy for a certain minimum period (e.g., 20 business days), and imposing a hefty 80% tax on capital gains realized by financial institutions from short-term trading. In fact, former Fed Chairman, Paul Volcker, has suggested that banks be barred from trading with their own money (they can trade in their client's account but not in their own account).
· Regulate hedge funds in the same way as mutual funds are regulated. Many of these hedge funds are funded by large banks, so if hedge funds fail because of excessive risk taking, they might bring down their sponsoring banks.
· Impose corporate governance rules that would require compensation plans for executives, traders, and loan officers to be approved by the shareholders.
· Impose a tax surcharge on companies that pay their CEOs and other highly paid employees more than a pre-specified limit. Also, the excessive compensation could be made non-deductible for tax purposes.
