Risk

The Federal Reserve proposes that it will “regulate” compensation packages at the top 28 financial institutions in the US. The agency said that its new program is designed to make sure that the incentive compensation policies of banking organizations do not undermine the soundness of their organizations.  The Fed will strongly encourage pay packages that curb inordinate risk-taking.  In plain English, the Federal Reserve has usurped most of the compensatio- setting power of boards of directors and the power of board risk management committees as well.

The role that the Fed is taking on is larger than it may seem at first. Digging for risk is a dirty business at banks with hundreds of billions of dollars in assets which trade financial instruments that can run into the trillions of dollars each year. It is an arduous business as well. The Fed’s idea is that it can ferret out what the banks themselves have not been willing to. That assumes that large American financial firms have the skills to appropriately fix risk levels in an industry in which risk is the core element to profitability.

The Fed program may be flawed because it represents a public encroachment on private enterprise prerogatives. It is, much more troubling, an arrogant assumption that a federal bureaucracy has the ability to do work that has challenged the best talent and best minds in the financial world. Even people with a genius for assessing risk make terrible mistakes from time-to-time and less significant ones regularly.

The most widely regarded investors of the last quarter century are the great hedge fund managers particularly George Soros and Julian Robertson, and Warren Buffett, the second richest man in the world by some measurements. Buffett has done well by taking comparatively little risk, although he has been burned badly in the insurance industry.  Soros became wealthy taking massive risks on macroeconomic trends. His returns were hurt badly more than once and his fund lost $5 billion during the Nasdaq collapse in 1999 and 2000. The Fed does not appear to be willing to admit that the finest minds in the financial world make miscalculations and some of them are nearly disastrous.

Regulation of financial risks at large banking firms is expensive and complex, and more problematic it is probably impossible. The global trading system among banks, government financial entities, and private pools of capital is based on the ability of the arbitrage and trade on inefficiencies in the market. Mortgage-backed securities are a signature example of the practice. The attempt to package securities that will do better than the markets that they derive from has been successful off and on, for decades. Millions of people and institutions trade puts and calls on stocks every day. It is a good way to make money and a great way to lose it.

The Fed does not have the tools or the culture to decide how people should be paid, particularly as related to the extremely complex transactions which are part of the daily business of the world’s largest financial firms.

The Fed could do the public and the shareholders of banks a tremendous service by insisting that these firms recruit highly expert board members, paying them regally, and forcing them to do what board members should—protect the interests of shareholders, customers, and the broad network of entities with which their firms do business and which, as a group, bear the weight of the economic system on their shoulders.

Douglas A. McIntyre