Bankers and Bebchuk on Compensation

Chief executives from top banks are on Capitol Hill today, testifying in an inquiry into what caused the financial crisis.  Although I am sure that they are not that keen on discussing compensation, they faced questioning on that topic.  Indeed it is impossible to separate compensation from other banking policies that led to the collapse. 

As we digest the bankers' testimony, it might be useful to compare their views on compensation with those expressed by Lucian Bebchuk in the paper he posted on SSRN, "Regulating Bankers' Pay."

Here is the abstract:

This paper seeks to make three contributions to understanding how banks’ executive pay has produced incentives for excessive risk-taking and how such pay should be reformed. First, although there is now wide recognition that pay packages focused excessively on short-term results, we analyze a separate and critical distortion that has received little attention. Equity-based awards, coupled with the capital structure of banks, tie executives’ compensation to a highly levered bet on the value of banks’ assets. Because bank executives expect to share in any gains that might flow to common shareholders, but are insulated from losses that the realization of risks could impose on preferred shareholders, bondholders, depositors, and taxpayers, executives have incentives to give insufficient weight to the downside of risky strategies.

Second, we show that corporate governance reforms aimed at aligning the design of executive pay arrangements with the interests of banks’ common shareholders — such as advisory shareholder votes on compensation arrangements, use of restricted stock awards, and increased director oversight and independence — cannot eliminate the identified problem. In fact, the interests of common shareholders could be served by more risk-taking than is socially desirable. Accordingly, while such measures could eliminate risk-taking that is excessive even from shareholders’ point of view, they cannot be expected to prevent risk-taking that serves shareholders but is socially excessive.

Third, we develop a case for using regulation of banks’ executive pay as an important element of financial regulation. We provide a normative foundation for such pay regulation, analyze how regulators should monitor and regulate bankers’ pay, and show how pay regulation can complement and reinforce the traditional forms of financial regulation.

MJB