In a study prepared by Professors Faulkender, Kadyrzhanova, Prabhala and Senbet, the authors make the following comment:
“And this incentive and externality problem is compounded by the moral hazard problem associated with federal deposit guarantees. Deposit-raising by banks is facilitated by deposit insurance provided by the FDIC. At non-bank companies, creditors are able to place restrictions on risk-taking through covenants and to “price” the risk-taking of the debtors in the debt contracts they negotiate with them. In the case of banks, the FDIC acts as an insurer and should be able to place similar restrictions on risk-taking. To the extent compensation contracts contribute to risk-taking, it is reasonable for the FDIC to place covenant-like restrictions on the compensation contracts of institutions that benefit from deposit insurance. A study by John, Saunders, and Senbet (2000) shows that if deposit insurance were priced to reflect the incentive features of bank management compensation, banks would be likely to pre-commit to a compensation structure that provides decision-makers with incentives to maintain their activities at a socially desirable level of risk and, in so doing, help maintain the stability of the banking system. As an alternative, bankers’ compensation could be adjusted to include payments that reflect not just the returns to equity, but the payoffs to depositors, bondholders, and other claimants. In such a case, compensation would depend on the value of the whole firm rather than the equity slice alone.”
This observation is completely wrong headed. Financial or similar covenants place the burden on the corporation, not directly on the individuals receiving the compensation. Even with covenants, there are material breaches and immaterial breaches. What causes the FDIC to act? What is reasonable compensation? Clearly the authors have no first hand experience on the wording of such a covenant. How would the covenant be drafted? Who pays the incremental legal fees? What are the remedies for a breach of the covenant? Will the bank go into default? Who does this protect? The shareholders, the depositors, the creditors? Academic theories versus practical realities are coming into play here. To use FDIC insurance as the means of reining compensation will lead to distortions in the market place. When does the FDIC pricing kick in? At all levels of compensation or above a threshold? What’s the pricing model? Whose pricing model? Placing more power in the hands of the regulator is not the solution. This creates a greater role for Washington to control economic activity which many do not believe is a good thing.
Deposit insurance was created to project the depositors to whom the financial intermediary has a fiduciary responsibility. Rather than discourage risk taking, it will encourage risk taking. The problem here is a seeming lack of goal congruence between management, shareholders, depositors and regulators. Riskier deals generate greater returns and require a greater allocation of capital. To the extent that the deal generates risk the deal will get booked subject to documentation as long as the risk adjusted rate of return is in excess of the hurdle rate. Riskier deals tend to generate more cash or operating income. More operating income generates more bonuses. It’s this nexus that needs to be examined. It would seem to me that an easier path to follow would be director and officer liability. The tools are already in place but need to be expanded. Banks and other financial intermediaries should not, however, be allowed to cover the risk to their directors and officers through corporately funded directors and officers liability insurance. That burden should be borne by the director or officer personally, with the corporation being the beneficiary under the policy. Insurance companies will be much better at pricing the risk than the FDIC. And the cost will likely be a wake up call to those concerned. Let the courts enforce the penalty. That’s what courts are for.