Business Research
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When the Fix Doesn't Fix the Problem

by Barbara Elmore

A simple timeline of the most recent financial crisis in the United States might read like this:

2008- Homeowners miss mortgage payments. Banks teeter; some fail. Manufacturing screeches to a halt. Unemployment and home foreclosures skyrocket.

2009-Bank failures continue. The U.S. government rescues institutions it calls "too big to fail."

2010-Government caps bank executives' pay, tying salaries to banks' earnings, ostensibly to curb risky loan-making. Taxpayers appeased.

2011 and outlying years: All is well.

All is not really well, however, and simple fixes are not always the answer to complex problems. Economics professor David VanHoose, who has been studying banking issues for the last decade, has discovered there is no clear cause-and-effect answer to the question about whether a government-dictated ceiling on pay ensures the right kind of behavior. His research, published in 2011 by the International Atlantic Economic Society, shows instead that such a pay cap can create more problems.

VanHoose, the Herman W. Lay Professor of Private Enterprise, approaches the issue of government regulation wearing not only an economist's hat, but also the mantle of industry experience. He has worked in both insurance and banking industries. His interest in banking began in the 1980s, but he moved away from the subject in the 1990s to focus on other areas. Ten years ago, he returned to banking topics with renewed interest, seeing risky behaviors of bank loan officers and under-funding of the Federal Deposit Insurance Corp., which insures bank deposits.

"I was taken aback by the whole thing," VanHoose said. Many people who should have foreseen the storm did not anticipate the disaster that unfolded in 2008, he noted, but some did. "The people who were paying attention knew there would be problems. There were people who understood this could happen, who said that the FDIC would not have enough cash to pay off even one or two large bank failures."

After dozens of banks failed and the government rescued many financial institutions to the dismay of taxpayers, it became clear that more regulations to prohibit risky behavior would follow. The result was laws that directed the Federal Reserve to establish formal regulatory standards for bank pay practices.

VanHoose's dismay with the panic and what happened next led him to begin researching the issue of pay regulations to learn more about why people were proposing that particular rule and what it might do. He dislikes the term "predatory lending," but he also knows that people sometimes do get taken advantage of. He wondered if, perhaps, he was looking at the "greedy banker" story, and if reasonable arguments existed for regulating bankers' pay.

His research, published in a paper titled "Regulatory Constraints on Performance-Based

Managerial Compensation, Bank Monitoring, and Aggregate Loan Quality," demonstrates that the full story about what happened, and what is likely to happen with new regulations, is more complex than a tale about a greedy banker taking liberties with a hapless borrower. His research also appears in a chapter titled "Regulation of Bank Management Compensation" in the book Financial Market Regulation: Legislation and Implications published by Springer in 2011.

In his research, the professor analyzed studies of management compensation schemes and the risks that bank managers take to see what government regulation of pay might mean to the banking business. His findings show little evidence that government restrictions on bankers' salaries would induce less risky behavior by bankers.

Instead, VanHoose suggests that regulating the pay of top people likely would lead to a shortage of exactly the kind of talented people banks need. The best-the most talented and experienced-will go into other industries where their pay is not capped and do the same thing there that they would have done for the banks. If they do stay at the bank, they may work less diligently at weeding out the riskiest loan prospects. "You have the opposite of what you wanted," he noted.

Additionally, this kind of pay regulation often leads to managers trying to get around explicit regulations by substituting perks for salary. Thus, regulations have the effect of making banks less efficient because they run up expenses unrelated to their primary purpose.

The banking problem is systemic, VanHoose said. The premiums that banks pay the FDIC to protect deposits have been too low almost since the time of the FDIC's creation in 1933. Most insurance works this way: When an insured person pays a private company for home, auto or health insurance, his premiums are based on what an actuary says is fair compared to other homes, autos or people in the same group. The government does not do that with FDIC insurance, and because it does not charge banks enough, bankers have an incentive to take a greater risk with loans, VanHoose said. "If things go sour, the FDIC stands ready, with taxpayer backing, to bail out the banks."

Not all banks take advantage of this shortcoming, but enough do to create problems. But more effective and straightforward than a rule regulating bankers' pay would be for the government to correct the flaw in FDIC funding by ensuring that it is actuarially sound. In short, asked VanHoose, "Why don't they just repair deposit insurance?" Despite calls to do so-including pleas by the FDIC itself to require the banks to pay more for insurance-there is little political will to make the changes necessary, VanHoose noted.

Experts at the Fed and the FDIC understand these issues, VanHoose said. But not everyone who crafts the laws of the land has the same understanding. And unfortunately, most people don't listen to economists-even to professors like Edward J. Kane of Boston College, who has predicted past banking breakdowns.

VanHoose intends to continue this line of research and believes that well-founded analyses can find their way to Washington through congressional staff members-and perhaps promote productive solutions over blaming bankers or the housing industry. "It's easy to act like you can dictate something," he added. "Producing a desired outcome is very different."

David VanHoose
Baylor University