Three and a half years have passed since the 2010 passage of the Dodd-Frank financial reform legislation. While some important elements of the law have been implemented (the Consumer Financial Protection Bureau has been hard at work, for example), other provisions simply seem to have been ignored. One crucial reform, targeted at Wall Street’s "heads I win, tails you lose" culture of lavish pay and nonexistent accountability, remains in bureaucratic limbo.
There’s no question that the flawed incentives in Wall Street pay packages played a major role in creating the financial crisis. The Financial Crisis Inquiry Commission, the official body charged with investigating the causes behind the financial and housing market crashes, found that pay systems too often encouraged “big bets” and rewarded short-term gains without proper consideration of long-term consequences. The practice of awarding large bonuses and other forms of immediate compensation creates incentives to ignore long-term risks and "take the money and run."
Former Securities and Exchange Commission Chair Mary Schapiro described the situation to the commission in this way: “Many major financial institutions created asymmetric compensation packages that paid employees enormous sums for short-term success, even if these same decisions result in significant long-term losses or failure for investors and taxpayers.” To take just one example, top executives of Bear Stearns and Lehman Brothers – the two big investment banks whose failure triggered the crisis – got paid $2.5 billion in the years leading up to the financial collapse. Despite their firms’ disastrous collapse, they got to keep every dime of it.
Risk-taking of this sort wasn’t always how things worked on Wall Street. In the decades after World War II, many of the big investment banks were private partnerships, meaning that senior managers' funds were constantly at risk and they could only collect their full payouts upon retiring, as opposed to in annual bonuses or stock options. During the decades after the war, in fact, pay inside the financial industry was roughly equal to pay outside of the industry. However, when investment banks went public in the 1980s and 1990s, bets were increasingly made with the money of shareholders, and firm pay structures began to reward the risk-taking that would lead to short-term paydays for companies, at the price of longer-term stability.
The Dodd-Frank financial reform law includes a specific provision to address precisely this problem, but it hasn’t been implemented yet. Section 956(b) of the law requires that financial regulators ban any type of incentive pay arrangements at banks that act to encourage inappropriate risk-taking. The statute tells regulators to write rules to implement the ban within nine months of the signing of the law. Yet today, almost four years after the law was passed, regulators still have not put these required restrictions on Wall Street pay in place.
What’s more, not only do the rules remain unfinished, but the initial proposal by the regulators was much too weak to get the job done. The regulators initial proposal to implement Section 956(b) includes general language telling bank boards of directors to design pay packages that don’t encourage excessive risk. But the major specific requirement in the proposal is that large banks set aside at least half of bonus payments to be paid out over three years. To comply with this requirement, a bank could pay their executives half of their bonus at the time it was earned, and then another third of the remaining half the next year, another third the year after that, and a final third three years after the bonus was earned. So as little as one-sixth of the total bonus could be deferred for the full three year period. This new requirement is weak compared to old partnership incentives that held executives’ wealth genuinely at risk based on the long-term consequences of their actions.
Furthermore, the rule doesn’t even ban the practice of "hedging" future compensation – so, for instance, an executive due a future deferred bonus who wanted to receive most of their money immediately could just sell the right to the deferred portion of the bonus in exchange for an up-front payment.
Finally, the specific pay requirements in the proposal cover only "executive officers," which includes only the CEO and major division heads of the bank, not the traders or other high-level employees below them. This is much too narrow. Individuals who are not covered could include many key decision-makers with the power to incur dangerous risks for the banks.
Since the release of this inadequate proposal, there has been no further action on implementing this crucial piece of financial reform. Why has the rule been so delayed and (so far) so weak? One answer is heavy lobbying. As Public Citizen noted in a 2011 report on the pay rule, companies that would be impacted by the new rules have spent hundreds of millions of dollars lobbying against its implementation, along with submitting comments in support of substantially weakening the rule. Another factor is the need for six different regulatory agencies to sign off on the rule, a process built for delay.
Today, the types of pay structures and incentives that contributed to the financial collapse are still in place. The six agencies responsible owe it to the public and the health of the financial system to take action to change them.