Todd Henderson of the University of Chicago Responds to Criticism of his Regulatory Proposal to Give Bank Regulators Compensation Based on the Performance of the Banks They Regulate

Earlier this Forum published a comment on a proposal by Prof. Todd Henderson of the University of Chicago to incentivize bank regulators with bonuses and phantom equity in the very institutions that they regulate and bonuses based on institutional performance.  We thought it was a very bad idea, actually a very stupid idea.

So in fairness here is the entire response Mr. Henderson made to the Post.

Todd HendersonJune 13, 2012 2:15 PM

If the "Dismal Political Economist" bothered to read the paper I (along with Fred Tung of Boston University) wrote, (s)he would have learned that we proposed paying a bonus to bank regulators tied mostly to bank debt in order to give regulators incentives to act more aggressively to restrict bank risk taking. But I guess it is easier to criticize a paper we didn't write instead of the one we did. 

If anyone is reading this blog -- and I have my doubts given this kind of sloppiness -- you can read the paper for yourself here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1916310.

  

Well Professor Henderson is correct in that we did not read his paper, mostly because we did not know such a paper existed since the news article in Businessweek that generated the post did not reference a paper.  Of course it is only fair to point out in our defense that now that we have read this paper we still reach the same conclusion. 

Compensating regulators by providing them with phantom equity positions in the companies they regulate or by incentivizing them with respect to regulating  risk is an unworkable concept, or at least one Mr. Henderson and his co-author have not worked out. The fact that they are confident things can be worked out does not work out for the rest of us.

We are confident that the optimal mix can best be determined

through trial and error. Potential error costs, however, counsel

for a gradual implementation of our proposal. Unlike executive

compensation, where experimentation can and does occur among

thousands of private firms, and a given firm’s poor pay design

would be unlikely to have widespread impact, error costs may be

high with regulator incentive compensation design. There are only

a few bank regulatory agencies, and a significant design mistake

could affect the entire banking sector, and perhaps beyond. Agency

heads should therefore proceed slowly and incrementally. The appropriate

debt-equity mix is an area for which more study and a

conservative approach are likely warranted.

Ah yes, the famous “more study is needed” answer to questions of practicality.

And even if it were somehow practical it is a really bad idea.(and in the interests of harmony we will drop the assertion that it is a stupid idea, apologize for using that term and simply claim that it is an impractical idea.)

And now we have read the paper, and it is a very nice paper indeed.

Pay for Regulator Performance

M. Todd Henderson 

University of Chicago - Law School 

Frederick Tung 

Boston University School of Law 

January 16, 2012

 It is long and it is well written and well researched.  It is full of footnotes (162 to be exact) and citations, which we like, and it is totally and completely in error of its basic supposition, that somehow financial regulators will be more effective if they have incentive compensation based on performance of the institutions they regulate.  It is also beyond the scope of this Forum and this post to comment completely on the paper, we must leave that for those who do that sort of thing once a paper is published.  But we can say a few things.

The very premise of the paper is one of the things that is false.  The premise is that regulators can in effect micro manage a financial institution.  This is not possible and it is not their jobs and it violates about every principle of non state owned business management that exists. .  The job of Congress is to set broad parameters of regulation.  The regulatory agency's job is to set forth rules, regulations, practices and procedures that the industry subject to regulation must follow.  The job of the examiners is to observe and monitor and report to see that the institutions are following those rules. 

Mr. Henderson and Mr. Tung have come up with an entirely new definition of regulation.  They make regulators quasi-executives, which is a radical departure from the role of examiners and individual regulators.  By going further, and providing for a large part of the compensation of these examiners to be dependent upon performance of the institution, they essentially turn regulators into managers whose focus is not longer enforcing regulations, but whose focus is on the performance of the securities of the entity they are examining. 

This position is premised in part on the principle that the market is completely efficient, and that the prices of the securities (the common stock, bonds, CDS's etc) of financial institutions fully reflect the risk and return in those institutions.  This premise will come as a surprise to investors in Bear Stearns, Lehman Brothers, Washington Mutual, Bank of America and so forth.  Could regulators really have prevented J. P. Morgan Chase from losing a couple of billion in hedging that wasn't hedging?  Heck J. P. Morgan Chase didn't even understand what they were doing, it would have been impossible for regulators to do so.  Mr. Henderson and Mr. Tung think Credit Default Swaps could be used in the compensation scheme.  If regulators really understood CDS's they wouldn't exist in their current role in the first place.

The paper and its policy recommendations are the very epitome of an excellent academic paper.  It is very well constructed and it has no applicability or understanding of how the world really works.