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Univ. of Toledo College of Law

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Sunday, February 7, 2010

Tung on Banker Pay for Performance

Pay for Banker Performance: Structuring Executive Compensation for Risk Regulation, by Frederick Tung,
Emory University - School of Law, was recently posted on SSRN.  Here is the abstract:

Excessive risk taking by firm managers did not originate with the Financial Crisis of 2007-08. Though bankers had special incentives to take big risks in the period before the Crisis, the incentive effects of equity-based compensation have been understood for some time. Bankers’ equity-based pay structure at the time of the Crisis was a natural outgrowth of the pay-for-performance movement that began in the 1990s and now informs all of corporate executive pay. Longstanding government guaranties of bank liabilities additionally served to intensify bankers’ risk taking incentives.

I propose to ameliorate this gamblers’ incentive with a new approach to compensation at the largest banks, one that explicitly accounts for the possibility of excessive risk taking and in-centivizes bankers against it. I propose that bankers be paid in part with public subordinated debt securities issued by their own banks. Market pricing of this debt will be particularly sensitive to downside risk at the bank. Including it in bankers’ pay arrangements and personal portfolios will therefore give bankers direct personal incentives to avoid excessive risk.

My approach has important advantages over recent banker pay reform proposals. The largest banks are owned and operated as wholly-owned subsidiaries of bank holding companies (BHCs), which also typically own other financial institutions. Two proposals – one by Lucian Bebchuk and Holger Spamann, and another by Sanjai Bhagat and Roberta Romano – would compensate bankers with BHC securities. But because BHCs own other institutions besides the given banking subsidiary, BHC securities can offer bankers only noisy and indirect incentives with respect to risk taking at the bank. My approach overcomes this problem by paying bankers with debt securities issued by the bank itself, a course unavailable with these other proposals.

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