by Jennifer Carpenter, Thomas Cooley and Ingo Walter
Now
that the Financial Reform and Consumer Protection Act of 2010 has been
passed by both houses of Congress, one of the key aspects that bear
watching will be its impact on compensation of senior management and
highly compensated risk-taking employees - who generally take home
around half of financial firms' earnings from wholesale banking
activities.
that the Financial Reform and Consumer Protection Act of 2010 has been
passed by both houses of Congress, one of the key aspects that bear
watching will be its impact on compensation of senior management and
highly compensated risk-taking employees - who generally take home
around half of financial firms' earnings from wholesale banking
activities.
Almost every investigation of the
financial crisis has provoked a fresh round of public and political
outrage as more details about compensation levels and practices at
financial institutions have come to light. The increase in executive
pay relative to median pay throughout corporate America has been a focal
point of media and investor attention for some time, but compensation
policy in the financial industry is among the most extreme. Regulators
and politicians have been quick to count compensation in the financial
sector as a major cause of the crisis, and many have advocated punitive
taxation and direct regulation including caps on cash bonuses and floors
on the proportion of share-based pay.
financial crisis has provoked a fresh round of public and political
outrage as more details about compensation levels and practices at
financial institutions have come to light. The increase in executive
pay relative to median pay throughout corporate America has been a focal
point of media and investor attention for some time, but compensation
policy in the financial industry is among the most extreme. Regulators
and politicians have been quick to count compensation in the financial
sector as a major cause of the crisis, and many have advocated punitive
taxation and direct regulation including caps on cash bonuses and floors
on the proportion of share-based pay.
Our view
is that compensation policy in the financial industry was not, by
itself, a real cause of the crisis. Although astronomical levels of pay
may offend most people's sense of fairness -- and wealth-redistribution
as opposed to wealth-creation -- they are not in themselves
destabilizing. What matters for financial stability is not the level of
compensation, but rather the risk incentives it creates. Compensation
structures during the period leading up to the crisis undoubtedly did
create incentives to take risks that were excessive from society's
viewpoint. But the source of this problem is that incentives for taking
excessive risk are built directly into bank equity itself and
consequently are a key responsibility of the board.
is that compensation policy in the financial industry was not, by
itself, a real cause of the crisis. Although astronomical levels of pay
may offend most people's sense of fairness -- and wealth-redistribution
as opposed to wealth-creation -- they are not in themselves
destabilizing. What matters for financial stability is not the level of
compensation, but rather the risk incentives it creates. Compensation
structures during the period leading up to the crisis undoubtedly did
create incentives to take risks that were excessive from society's
viewpoint. But the source of this problem is that incentives for taking
excessive risk are built directly into bank equity itself and
consequently are a key responsibility of the board.
It's
long been recognized recognized that holders of highly-levered equity,
protected by deposit insurance or too-big-to-fail guarantees, have
incentive to maximize the value of that equity at taxpayer expense by
taking big bets. Capital requirements and restrictions on banking
activity were supposed to address this conflict of interest between
financial firm shareholders and taxpayers. But deregulation of banks and
innovation in financial products either explicitly or effectively
loosened these constraints. In retrospect, it seems clear that
shareholders, and their boards, condoned and even encouraged many of the
risky activities for which high-profile managers and traders have been
blamed, such as accumulating large inventories of dodgy but profitable
assets.
long been recognized recognized that holders of highly-levered equity,
protected by deposit insurance or too-big-to-fail guarantees, have
incentive to maximize the value of that equity at taxpayer expense by
taking big bets. Capital requirements and restrictions on banking
activity were supposed to address this conflict of interest between
financial firm shareholders and taxpayers. But deregulation of banks and
innovation in financial products either explicitly or effectively
loosened these constraints. In retrospect, it seems clear that
shareholders, and their boards, condoned and even encouraged many of the
risky activities for which high-profile managers and traders have been
blamed, such as accumulating large inventories of dodgy but profitable
assets.
Some compensation practices, such as
paying bonuses based on "fake alpha" (excess returns determining current
bonuses that later turn out to be illusory), induced systemic risk at
the expense of both shareholders and taxpayers. However, shareholders
of the major financial firms evidently were largely supportive of
compensation policy. Indeed, in the face of supervision that might have
strengthened their hand at the bargaining table with highly compensated
employees and managers, boards of bailed-out financial firms scrambled
to pay back government loans primarily to regain freedom to grant the
signing bonuses and pay guarantees they felt were necessary to attract
and retain the talent they felt added value.
paying bonuses based on "fake alpha" (excess returns determining current
bonuses that later turn out to be illusory), induced systemic risk at
the expense of both shareholders and taxpayers. However, shareholders
of the major financial firms evidently were largely supportive of
compensation policy. Indeed, in the face of supervision that might have
strengthened their hand at the bargaining table with highly compensated
employees and managers, boards of bailed-out financial firms scrambled
to pay back government loans primarily to regain freedom to grant the
signing bonuses and pay guarantees they felt were necessary to attract
and retain the talent they felt added value.
While
we are in favor of compensation reforms in the financial sector, we
argue that the solution is not direct pay regulation, involving hundreds
of thousands of contracts between firms and highly compensated staff
with heterogeneous preferences and skills, but rather a rewriting of the
basic contract between taxpayers and the financial firms themselves.
With new regulatory initiatives that place restrictions on lines of
business that are protected by federal guarantees, correct pricing of
deposit insurance, taxation of systemic risk, higher capital
requirements, and other measures discussed in this book, much of the
compensation problem is likely to resolve itself. If the incentives
facing shareholders at financial firms can be better aligned with those
of taxpayers, for example, through correct pricing of guarantees and
taxation of systemic risk, then it remains only to strengthen
shareholder rights as much as possible and leave shareholders
representatives on boards to provide managers with the right incentives.
we are in favor of compensation reforms in the financial sector, we
argue that the solution is not direct pay regulation, involving hundreds
of thousands of contracts between firms and highly compensated staff
with heterogeneous preferences and skills, but rather a rewriting of the
basic contract between taxpayers and the financial firms themselves.
With new regulatory initiatives that place restrictions on lines of
business that are protected by federal guarantees, correct pricing of
deposit insurance, taxation of systemic risk, higher capital
requirements, and other measures discussed in this book, much of the
compensation problem is likely to resolve itself. If the incentives
facing shareholders at financial firms can be better aligned with those
of taxpayers, for example, through correct pricing of guarantees and
taxation of systemic risk, then it remains only to strengthen
shareholder rights as much as possible and leave shareholders
representatives on boards to provide managers with the right incentives.
For
this reason, we favor many of the G-20 and US legislative provisions
for executive compensation. These strengthen shareholder rights by
mandating nonbinding shareholder votes on executive pay and better
disclosure of compensation policy and the permissibility of managerial
hedging, yet do not tie boards' hands with more rigid regulation of
compensation structure. We also strongly support the Federal Reserve's
plans for regular review of compensation in the financial sector, and
hope that it will generate a large database on compensation in the
financial industry that will spur compensation reform in the future.
this reason, we favor many of the G-20 and US legislative provisions
for executive compensation. These strengthen shareholder rights by
mandating nonbinding shareholder votes on executive pay and better
disclosure of compensation policy and the permissibility of managerial
hedging, yet do not tie boards' hands with more rigid regulation of
compensation structure. We also strongly support the Federal Reserve's
plans for regular review of compensation in the financial sector, and
hope that it will generate a large database on compensation in the
financial industry that will spur compensation reform in the future.
With
sufficient alignment of taxpayer and shareholder interests, and
sufficient strengthening of shareholder rights, we expect to see
compensation reform emerge largely on its own. What might elements of
sensible compensation policy at financial firms include?
sufficient alignment of taxpayer and shareholder interests, and
sufficient strengthening of shareholder rights, we expect to see
compensation reform emerge largely on its own. What might elements of
sensible compensation policy at financial firms include?
• Stock-based
or other performance-based pay, without predetermined minimums, to
create an incentive to add value through efficiency and innovation;
or other performance-based pay, without predetermined minimums, to
create an incentive to add value through efficiency and innovation;
• Ex-ante risk adjustment of performance measures, to discourage the pursuit of illusory "fake alpha" profit;
• Deferred cash compensation, or "inside debt," to give managers an interest in the long-term solvency of the firm;
• Claw-backs, or "maluses" to give managers a tangible personal interest in controlling downside risk;
• Guaranteed
cash compensation (the G-20 recommendations notwithstanding) to attract
and retain talented personnel and compensate them for the risks they
may personally be forced to bear.
cash compensation (the G-20 recommendations notwithstanding) to attract
and retain talented personnel and compensate them for the risks they
may personally be forced to bear.
Note that our
list does not preemptively include caps on cash compensation or floors
on the proportion of stock-based compensation. More stock-based
compensation might only aggravate the perverse incentives problem if
taxpayer/shareholder conflicts persist. Capping pay also seems
heavy-handed. For example, financial firms may need to raise cash
compensation to managers in return for forcing them bear more downside
risk in stock-based compensation and lock-ups. And we have noted that
average pay levels at these institutions could very well decline on
their own if the Volcker Rules and other restrictions on banking
activity ultimately mean these firms find less use for high-priced
talent, and the affected employees depart for better opportunities
elsewhere.
list does not preemptively include caps on cash compensation or floors
on the proportion of stock-based compensation. More stock-based
compensation might only aggravate the perverse incentives problem if
taxpayer/shareholder conflicts persist. Capping pay also seems
heavy-handed. For example, financial firms may need to raise cash
compensation to managers in return for forcing them bear more downside
risk in stock-based compensation and lock-ups. And we have noted that
average pay levels at these institutions could very well decline on
their own if the Volcker Rules and other restrictions on banking
activity ultimately mean these firms find less use for high-priced
talent, and the affected employees depart for better opportunities
elsewhere.
Is endogenous compensation reform
too much to hope for? Perhaps. But fixing the obvious conflicts
between shareholders and taxpayers, strengthening shareholder power, and
then giving market discipline a chance seems like the best place to
start.
too much to hope for? Perhaps. But fixing the obvious conflicts
between shareholders and taxpayers, strengthening shareholder power, and
then giving market discipline a chance seems like the best place to
start.
