Starting the new year off, regulators are working on a pile of new rules that will soon resemble he pile-ups we’re seeing all too often on snow-bound interstates. As each regulator uses its authority to attack one or another of the problems it thinks led to the crisis, the agencies increasingly seem hell-bent on plowing their monster trucks into whatever stands in their way regardless of the collateral damage this may cause. Case in point: the FDIC proposal next week that will make compensation a criterion for computing risk-based premiums. It isn’t the only proposal in the pile-up. It is, though, emblematic of the ongoing regulatory over-correction.
This isn’t to say that a lot of new rules aren’t warranted. They are, particularly in the capital, transparency, counterparty exposure and concentration arenas. We’ve talked a lot about them in recent months and will have more to say shortly in the wake of the latest batch of sweeping proposals from Basel, the Joint Forum and U.S. bank regulators. For now, we’d just like to reiterate before criticizing the growing rule mountain that we don’t intend this to be taken in any way as support for the status quo, let alone that ex ante.
Now, on to our target: the likely FDIC proposal linking risk-based deposit-insurance premiums to compensation practices. We think this is a bad idea for two reasons: first, compensation is the least of the risks that results in bank failure and, second, there are far more potent, proven forms of risk the FDIC has wholly ignored. And, if this isn’t enough, there’s a third reason we think it’s a bad idea. Even if one buys into the principle of attacking compensation in risk-based premiums, no one has done any of the analytics figuring out how to price for it. As a result, putting compensation into the calculation is another deep step not into risk-based pricing, but rather a step on the increasingly well-trod road to political-based pricing.
We’ve been complaining about the lack of risk in the FDIC’s risk-based premiums since they were first put in place in 1992. A good deal more recently, we similarly argued that the rewrite following Congress’ 2005 requirements was, at best, a very modest improvement. As clients will recall, the latest version of the FDIC’s risk-based premiums links charges to CAMELS ratings (pretty imperfect judging from the high-rated corpses now on the FDIC’s hands) and credit rating agency determinations – whoops. Risk concentrations aren’t on the list, nor is over-reliance by non-bank affiliates on insured deposits, liquidity mis-matches, big books of off-balance sheet paper or an array of factors well known before the crisis to be strong leading indicators of growing risk. Although new premiums won’t stop bad practice, the FDIC could have played a critical role holding other regulators’ feet to the fire if it had factored these risks into the premium schedule, which it could have done in light of all the work over recent years quantifying and pricing these risks. It wasn’t done well, of course, but at least it was done.
To be sure, incentive misalignment is a big risk driver. But, is this principally in executive compensation – at which the FDIC will take aim – or, far more importantly, in the broader asset-structuring and securitization arenas? We think the latter issue is far more potent from a prudential perspective than a few bankers making whoopee with ill-gotten gains. Regulators can and should deal with the bonus babies – and, in fact, now they are both through the FRB’s recent guidance, the new SEC rule and pending legislation. Piling up an FDIC rule that would attempt without underlying analytics first to quantify the risk impact of bank compensation and then price for it would add a very big 18-wheeler to a regulatory monster-truck derby that’s already showing dangerous signs of wiping out pedestrians.