Question

In the United States, the Dodd-Frank Act, passed in 2010, requires bank holding companies with more than $50 billion in assets to abide by stringent capital and liquidity standards and it sets new restrictions on managerial incentive compensation.

(Btw, it there any relationship between capital and liquidity standards and restrictions on managerial incentive compensation?)

Critically evaluate the arguments for and against the stringent capital and liquidity standards and restrictions on managerial incentive compensation in the banking sector.

Answer 1

The establishment of stringent capital and liquidity standards is essential to ensure that the bank is adequately capitalised at all times. Also it implies that any erosion in reserves due to bad loans do not lead to any systemic contagion which could potentially impact the entire financial sector. A major shortcoming of having excess capital reserves is that the ability of the banks to extend credit and leverage their balance sheets may get affected due to the need to maintain capital reserves.

The restrictions on managerial compensation is also important as it promotes prudent behaviour and prevents undue risk taking. A disadvantage is that a restriction on compensation may prevent management from striving hard enough and also act as a constraint in attracting best talent.