The Futile Quest for an Effective Incentive Structure - Chicago Law School - Feb 2009

Throughout
this course, we have confronted the question of how to prevent managers
from taking the sort of high-stakes risks that they are legally
entitled, yet not necessarily well advised, to take. I’ve become more
and more skeptical that manipulation of managers’ incentives alone will
solve the problem, and Prof. Rajan’s excellent article drives another
stake into the little hope I do retain. First, the direct relation of
compensation to returns means that managers have an incentive to take
tail risks—this we already knew. In theory, tying compensation to
long-term results—however those are defined—would mitigate this
problem. But as Rajan explains, managers’ incentives are further
affected by A) the indirect relation of compensation to returns “via
the quantum of assets [under management]” and B) the insurance provided
by engaging in herding behavior. The former fact seems to work against
the successful tying of compensation to long-term results; not only is
present investor exit more salient than intangible future returns, but
what’s the point of safely getting from point X to point Y if the
quantity of assets under management has significantly decreased?
Furthermore, nothing about tying compensation to long-term results
addresses the herding problem; if managers are herding on the
assumption that if something goes bad, at least they won’t be
personally culpable, there’s no reason this should be less true five
years from now than it is today.

Predictably, managers of these
financial institutions have been increasingly <a
href="http://www.apple.com/trailers/sony_pictures/theinternational/">vilified</a>
in the press, and measures are being taken to severely restrict—or at
least appear to restrict—executive compensation. President Obama’s
proposal can be found <a
href="http://www.ustreas.gov/press/releases/tg15.htm">here</a>,
and components of a recent amendment from Congress can be found <a
href="http://www.cnn.com/2009/POLITICS/02/14/stimulus.pay/">here</a>.

Obama’s proposal:
•    Caps senior executive compensation at
$500K, exclusive of restricted stock that vests when the government has
been repaid, for companies receiving “exceptional financial recovery
assistance”;
•    Allows other companies receiving governmental
assistance to waive these requirements through disclosure and
shareholder vote.
Congress’s amendment:
•    Bars senior
executives from receiving bonuses that exceed one-third of total annual
compensation, <a
href="http://blogs.harvardbusiness.org/hbreditors/2009/02/reaping_the_exec_comp_whirlwin.html">without
putting a cap on salaries</a>. Bonuses must be in restricted
stock, as above. The number of executives affected depends on the
amount of assistance received.

These plans present several
problems, many of them outlined by Prof. Becker and Judge Posner on
their <a href="http://becker-posner-blog.com/">blog</a>.
•   
To the extent that recovery will depend on being able to attract new
talent at the top, the restrictions will make that more difficult. This
isn’t to say that executives will leave the banking industry en masse;
it simply suggests that those struggling institutions that have
received governmental assistance and need strong management the most
will be the least able to attract it.
•    The restrictions will
encourage companies to terminate or avoid financial assistance. They
will also encourage executives to waste resources attempting to find
loopholes in the legislation.
•    Notwithstanding the above
criticisms, the restrictions also seem strangely toothless in the sense
that Obama’s proposal places no constraints on the amount of
performance-based compensation, while Congress’s amendment fails to
constrain the metric (salary) against which performance-based
compensation is fixed. Furthermore, the restrictions don’t apply to
past equity compensation.

More generally, these measures seem
entirely populist and punitive, and don’t reflect any real effort to
craft pay structure in a way that will discourage the practices that
led us into this situation in the first place. This brings me back to
my initial question: what can be done to mitigate the risk-taking
behavior of managers? The President and Congress appear to think that
restricted stocks hold (some of) the answer, but while this lengthens
the horizon that managers must consider, I don’t see how it truly
addresses the powerful herding problem that Rajan identifies. It
increasingly looks like constraints must be imposed from the outside
rather than fostered internally.