The Consumer Financial Protection Bureau: Reining in Greed

“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”

--Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations

The assumption behind Adam Smith’s concept of the “invisible hand of the marketplace” is that if participants in a free market seek to maximize their personal gains, society will benefit as a whole even though the individuals have no other motivation beyond their self-interest. The character of Gordon Gekko in the 1987 film Wall Street expressed the idea succinctly with his exhortation that “greed is good.”

However, in practice there have been a few problems with relying completely on “the invisible hand.” First, for numerous psychological reasons people do not always act according to their self-interest. For example, many people are greedy and greed is not the same as self-interest.  Greed is a self-destructive desire that is listed as one of the “seven deadly sins.” Second, people do not always know the course of action that is in their self-interest. In our modern complex economy the best financial decision for an individual is not always obvious. Most agreements concerning mortgages, consumer financing products, credit cards, and bank accounts are complex contracts that are difficult for anyone to fully understand. Without knowledge and understanding it is not possible for consumers to act in their self-interest.

The government can do little to change human nature, but it can put in safeguards against its excesses. For example, the government can require that financial contracts be written so that consumers actually understand the agreements. To better inform consumers, in 2011 the federal government created the Consumer Financial Protection Bureau (CFPB). The purpose of the bureau is to regulate consumer financial products so that the agreements are fair and transparent. But, since its inception, the CFPB has been excoriated by the banking industry, and the bankers have unleashed lobbyists in Congress in a successful bid to limit the CFPB’s effectiveness.

The irony of this hostile action against the CFPB is that the banks blamed consumers for the financial crisis. Consumers purchased homes that they couldn’t afford, falsified mortgage applications, charged too much on credit cards, and in general didn’t understand the obligations and consequences of the agreements they signed. In other words, consumers were greedy and greed isn’t good for the banks.

However the banks want to continue the same consumer lending practices that preceded the financial crisis. Without the obfuscation and one-sidedness characteristic of many of their lending agreements, the banks feel that they can no longer profit. In other words, greed is good for the banks, except for the fact that it wasn’t, which is why so many of them failed.

Complex contracts designed to disguise inherent unfairness, benefit neither party. If a contract is so one-sided that a clear understanding of its terms would not lead to an agreement, it is better for both parties that there be no agreement. The banks should actually be vocal advocates of the CFPB because adequate regulation would insure a level playing field.

Much like the role of drug testing in sports, in which no competitor should be able to get an unfair advantage by engaging in unhealthy practices, financial product regulation should serve the same purpose – keep all players healthy.

But the banking industry continues to push for unfair advantages because greed is good. In other words, greed drives the market. At least until the market crashes, in which case the destructive consequences of greed are everyone else’s fault and everyone else should have to pay.

What is often overlooked in Adam Smith’s quote is that the butcher, the baker, and the brewer all need each other if they are each to have a complete meal. If greed ruins anyone of them, it will ruin them all. In other words, greed is not good and it is not what Adam Smith meant by self-interest.

UK Trip Part I: Executive Compensation

I just returned from a trip to the UK where I spent four days touring London and then four days at Cambridge University where I gave a talk about the mortgage crisis in the United States. It struck me perusing the London media just how many of the banking problems in the UK mirror those in the US and even more striking, how the rhetoric matches word-for-word.

A British tabloid-style newspaper—The Independent—ran a headline on August 4: ‘Big bonuses? It would be wrong to stop paying them.’ Beneath it ran the subheading: "Barclays’ £50m-a-year boss delivers a defiant rebuff to critics who say bankers are overpaid." Quotes in the article could have been lifted from the financial section of any newspaper in the US. Here is a sampling:

“performance-related bonus payments were vital given the bank's "obligation to run a client-first business”

“It is pay for performance and it is based on principles we have followed for a while now.”

“It would be wrong for the bank not to pay out ‘if we had really good performance.’”

And my favorite quote described seven-figure bonuses as:

“essential if we want people to work in our industry”

When I returned home, the first headline I saw in my local paper, the Baltimore Sun read: “CEOs paid more even as profits fall” followed by the subheading: “Debate swirls as most of the area's 10 top-earning CEOs receive higher compensation during a recession that has dragged down many companies' stock prices and profits.”

The reporters analyzed the compensation for 20 Baltimore-area companies that paid their CEO at least $1 million and found that 17 received compensation increases even though in most cases company profits fell. The reporters obtain their compensation figures from documents filed with the SEC. The company spokepersons who responded to questions couldn’t give the usual “pay for performance” justification without sounding completely out of touch with reality. Instead elaborate mathematical manipulations were offered to convince everyone that the figures for executive pay on SEC-required filings were misleading because of SEC-enforced rules. The spokespersons insisted that the pay the CEOs actually received was much lower. I don’t know if I should take comfort in the argument that federal law requires that SEC documents misrepresent actual pay.

It occurred to me as I read the articles in Baltimore and London that no matter what order of magnitude is attached to compensation figures, spokespersons for the industry will argue that it must be at that level. As the recession squeezes budgets, teachers with 5-figure incomes warn public education will suffer if salaries are cut, medical doctors making 6-figure incomes warn that public health will suffer if government-run healthcare puts limits on their income, and here we have bankers with 7-figure incomes arguing that banks will fail to function if CEO compensation is limited. It appears that compensation is like closet space, no matter how much you have, expenses will expand to require all of it. Any reduction in income then becomes unimaginable.

However, I find the logic for executive compensation interesting on many different levels. First it would be interesting to know if independent studies have found cause and effect relationships between executive pay and company performance. Recently I came across a study on the relationship between the cost of executive homes and company performance.

Two business professors, Crocker H. Liu and David Yermack, conducted a study reported in a paper titled: "Where are the Shareholders Mansions? CEOs Home Purchases, Stock Sales, and Subsequent Company Performance." The study found an inverse relationship between company performance and CEO stock sales to finance large real estate purchases. In other words the bigger the CEO’s home the worse the company performs. The authors concluded that, “regardless of the source of finance, future company performance deteriorates when CEOs acquire extremely large or costly mansions and estates.” It is wrong to generalize from a single study but it does suggest that the justifications for high executive compensation might not hold up when the facts are examined.

A large part of the problem as Jay Hancock pointed out in a recent column is that CEO pay is not negotiated with the company owners. Boards of directors determine CEO pay, not the shareholders who actually own the company. As a result market forces don’t work, an observation made by the father of free-market capitalist principles Adam Smith more than two centuries ago. It is worth reading the entire section below from Smith’s treatise The Wealth of Nations because it describes exactly the problems with executive pay today.

“The trade of a joint stock company is always managed by a court of directors. This court, indeed, is frequently subject, in many respects, to the control of a general court of proprietors. But the greater part of those proprietors seldom pretend to understand anything of the business of the company, and when the spirit of faction happens not to prevail among them, give themselves no trouble about it, but receive contentedly such half-yearly or yearly dividend as the directors think proper to make to them. This total exemption from trouble and from risk, beyond a limited sum, encourages many people to become adventurers in joint stock companies, who would, upon no account, hazard their fortunes in any private copartnery. Such companies, therefore, commonly draw to themselves much greater stocks than any private copartnery can boast of. The trading stock of the South Sea Company, at one time, amounted to upwards of thirty-three millions eight hundred thousand pounds. The divided capital of the Bank of England amounts, at present, to ten millions seven hundred and eighty thousand pounds. The directors of such companies, however, being the managers rather of other people's money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. It is upon this account that joint stock companies for foreign trade have seldom been able to maintain the competition against private adventurers. They have, accordingly, very seldom succeeded without an exclusive privilege, and frequently have not succeeded with one. Without an exclusive privilege they have commonly mismanaged the trade. With an exclusive privilege they have both mismanaged and confined it.”

Adam Smith understood that “negligence and profusion” would always prevail in the management of publicly traded companies because the directors are not the owners. Of course newspapers like to report on the excesses of high-living executives and print their self-serving explanations because of the public outrage stirred. There is an obvious “two-headed quarter” in play that angers people. Executives profit handsomely when performance is good and profit handsomely when performance is bad.

However, I see an attitude that is even more deeply troubling. Beyond the conflicts of interest Adam Smith described, the idea that seven-figure salaries are essential or there would be no executives might be a more revealing testament to the cause of dysfunction in corporate America.

For most people pay is a necessary condition to work but not sufficient. Motivating people to do a job well usually requires more than money. For many people work is an opportunity to perform a social good and contribute to a cause larger than oneself. Teachers teach and doctors practice for reasons beyond money.

But, the apologists for high executive pay, talk about compensation and performance only in monetary terms. This is an attitude that does a disservice to the majority of their own employees. When I go into my bank the people who work there seem genuine in wanting to help me. It is a social transaction, not just financial.

I am well aware that in any industry, compensation is determined by market forces that have more to do with scarcity than the value of the work to society. It is for those reasons major league baseball players will always make orders of magnitude more than teachers. But success in teaching and sports is usually defined in non-financial terms. To do the work requires a desire for more than just money.

The evaluation of executives needs to include more than just financial measures. There needs to be ethical and societal dimensions when evaluating the performance of executives because the decisions they make have impacts far beyond the company stock price. The underlying assumption behind performance evaluation—rising stock price equals good; falling stock price equals bad—is overly simplistic. When large companies fail many more people than the shareholders lose.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy