Bebchuk & Spamann on Regulating Bankers' Pay

Regulating Bankers’ Pay, by Lucian A. Bebchuk, Harvard University - Harvard Law School; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI), and Holger Spamann, Harvard University - Harvard Law School, was recently posted on SSRN.  Here is the abstract:

This paper contributes to understanding the role of executive compensation as a possible cause of the current financial crisis, to assessing current legislative and regulatory approaches meant to discourage bank executives from taking excessive risks, and to identifying how bankers’ pay and banks should be regulated going forward. Although there is now wide recognition that executives’ decisions might have been distorted by the short-term focus of pay packages, we identify a separate and critical distortion that has received little attention. Because bank executives have been paid with shares in bank holding companies or options on such shares, and both banks and bank holding companies issued much debt to bondholders, executives’ payoffs have been tied not to the value of banks’ capital but to highly levered bets on this value. These highly levered structures gave executives powerful incentives to under-weight downside risks. We show that current legislative and regulatory attempts to discourage bank executives from taking excessive risks fail to address this identified factor. In particular, recently adopted requirements aimed at aligning the interests of executives tightly with those of the common shareholders of bank holding companies – through emphasizing awards of restricted shares in these companies and introducing 'say on pay' votes by these shareholders – miss the mark. The common shareholders of bank holding companies, especially now that the book value of their investment has decreased so much, would be better served by much more risk-taking than would be in the interest of the government as preferred shareholder and guarantor of some of the bank’s obligations. Finally, having identified the problems with current attempts and proposals, we analyze how best to implement recent legislative mandates that require banks receiving financial support from the government to avoid providing executives with incentives to take excessive risks. Beyond banks receiving governmental support, we put forward a novel strategy for banking regulation; we argue that monitoring and regulating bankers’ pay should be an important element of banking regulation in general, and we analyze how banking regulators should assess and regulate bankers’ pay.