Regulating Compensation For Bank Executives

Lawrence J. White,
06.19.09, 12:45 PM EDT

Because improved corporate governance isn't enough, creditors should have oversight.

The
compensation structure for senior bank executives is now generally
recognized as a problem. Bankers were rewarded for taking large risks:
If the coin landed on heads, the bank (and the banker) profited; on
tails, the bank failed, shareholders lost and taxpayers were required
to bail out the bank's creditors.

Although Obama's "Financial
Regulatory Reform" proposals announced on Wednesday address
compensation issues only incidentally, in the context of
securitizations, Treasury Secretary Timothy Geithner
issued a statement a week earlier that expressed the administration's
broader concerns about the structure of compensation in financial
companies. The major remedies that he proposed to protect these
companies involved improvements in corporate governance, for example,
allowing "Say on Pay" votes by shareholders and strengthening the
independence of compensation committees.

This approach is in the spirit of Alan Greenspan's
testimony before Congress last October, in which he famously stated:
"Those of us who have looked to the self-interest of lending
institutions to protect shareholder's equity (myself especially) are in
a state of shocked disbelief."

Alas, this approach--focusing on
improved corporate governance to rein in these "cowboy" executives--may
well be inadequate. It leaves out the effects of leverage, limited
liability and portfolio diversification. Diversified shareholders might
prefer compensation structures that actually encourage excessive
risk-taking.

Let me explain.

Suppose that Mr. Greenspan
owned an investment bank. The assets of Greenspan's bank are $100. His
ownership stake (the bank's "capital") is $10. The remaining $90 of
assets are funded

more...http://www.forbes.com/2009/06/19/regulation-leverage-creditor-opinions-contributors-bank-compensation.html