The hypocrisy of the Fed

The Fed is reportedly looking to monitor banker pay in order to discourage excessive risk-taking. But aren't the Fed's easy money policies encouraging risk?

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By Paul R. La Monica, CNNMoney.com editor at large

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NEW YORK (CNNMoney.com) -- Are there any mirrors in the headquarters of the Federal Reserve? If so, I think it's time for Ben Bernanke and his colleagues to look into one.

The Fed, according to a Wall Street Journal report Friday, is said to be considering a plan that would allow regulators to closely monitor and even change the pay practices at financial firms in order to make sure that these companies aren't encouraging excessive risk-taking.

Considering that the mess that we find ourselves in is partly due to big banks and insurance firms failing to recognize the many subprime warning signs in order to satisfy Wall Street's myopic focus on quarterly profits, reining in bonuses and other compensation tied to stock performance may not sound like a bad idea.

But riddle me this Bat-readers: Isn't it more than a tad hypocritical for the Fed to be trying to tell banks that too much risk is a bad thing?

After all, the Fed has kept its key overnight bank lending rate near 0% since December and has shown no indication that it will raise this rate anytime soon.

And the Fed has pumped trillions of dollars into the financial system through a variety of programs in order to try and get banks to loan more again. The business of lending is inherently risky. So what kind of message is the Fed trying to send here?

"It makes absolutely no sense at all. It is completely counterintuitive," said Haag Sherman, managing director with Salient Partners, an investment firm in Houston. "The government wants to impose more regulations and put shackles on compensation but in the next breath everybody is screaming about banks not lending."

It's hypocritical plain and simple. Isn't all this cheap money designed to push banks to take on more risks? The Fed wants to slap banks on the wrist for paying its employees too much because that might encourage them to get reckless. But at the same time, the Fed is tempting banks to lapse into bad habits with what may be an overly accommodative monetary policy.

This is the equivalent of your doctor telling you that he wants to approve every meal you eat for the next few months so you don't gain a lot of weight -- while handing you coupons for McDonald's and Krispy Kreme on your way out of the office.

Now of course, many big financial firms are guilty of helping to bring about the financial crisis as the promise of fantabulous bonuses undoubtedly caused them to put on blinders and ignore risk.

"There was no acknowledgment that the derivatives they were writing had a risk. The biggest issue with compensation at financial firms is that it was like paying people before the roulette wheel stopped spinning," said Barry Ritholtz, CEO and director of equity research at research firm Fusion IQ in New York.

But there is a lot of blame to go around.

Consumers got suckered into thinking that the American dream wasn't just owning a home but owning a home with as little money down as possible so they could quickly flip it and buy another one. Greedy mortgage brokers and appraisers helped indulge this.

But many believe the the root cause of the housing bubble is that interest rates were extremely low for an extended period of time. And that's mainly the Fed's fault. During the 2001 recession, the Fed slashed interest rates, bringing them down to 1% by June 2003. And it held them at 1% for a year.

With that in mind, why should the Fed have the power to dictate compensation packages -- especially since it may be in the process of making the same mistake all over again by signaling it's going to keep rates at zero for a while.

"The Fed was a major cause of this downturn. So why reward them with more authority? And now they're saying don't take risks but by the way, here's a whole lot of easy money," Ritholtz said.

Don't get me wrong. I'm not suggesting that bank CEOs, other senior executives and traders should be rewarded for failure. And if the government has a major stake in a financial institution, I think regulators should be more active in protecting the interest of taxpayers.

I have no problem if the government wanted to, for example, tell new AIG (AIG, Fortune 500) CEO Robert Benmosche that he can't make as much as he did when he ran MetLife (MET, Fortune 500) or use AIG's corporate jet for personal purposes. (What was Benmosche thinking? Did all the stories about AIG bonus rage not reach his villa in Croatia? Thank heavens the board turned him down.)

Regulators should also be allowed to look more closely at and crack down on excessive compensation at the likes of Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500) as long as they remain tethered to TARP. That's the price these institutions pay for needing what the government euphemistically describes as "exceptional assistance," and you and I would call a bailout.

But the Fed's plan is supposedly going to apply to the more than 5,000 banks that it regulates. That's not fair to the many banks that didn't screw up and were in a strong enough financial position to turn down the government's "rescue" plan.

Plus, this looks like more of a power grab by the Fed than anything else. The Fed appears to want to run an end-around on Congress and avoid legislative scrutiny.

Ritholtz argued that other agencies, such as the SEC and FDIC, should be the ones that have more authority over scrutinizing compensation packages at banks. He thinks the Fed should stick to its primary role as a monetary policy maker.

Sherman goes one step further. He doesn't think the government should have any role in dictating pay. He said that should be up to investors in the financial firms.

"To me, the most sensible thing is to give shareholders more say and give them more transparency about compensation in proxy statements," he said.

Of course, it's not that simple. And it's actually going to take action from Washington to give shareholders that power. The House passed a so-called "say on pay" bill earlier this summer but the Senate has yet to vote on its own version.

Hopefully, shareholders will have more of a say soon. They deserve it more than the Fed.

Talkback: Should the Fed or other government agencies have the power to limit executive compensation? Share your comments below. To top of page

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