Is Restricting Pay the Silver Bullet?

Is Restricting Pay the Silver Bullet? November 9, 2009   Bob Eisenbeis, Chief Monetary Economist

Financial institution regulators around the world have coalesced around the idea that the way to control excessive risk taking is to restrict bankers’ pay.  In part they are responding to taxpayer ire at their having put billions of dollars of rescue funds into financial institutions, only to see those institutions pay what are viewed as outlandish bonuses and incentives to senior executives, traders, and other key employees.  That outrage is understandable.  But the key question is whether high salaries and incentive pay encouraged increased risk taking that played a significant role in causing the current financial crisis, or is that compensation simply an example of a few talented executives capturing economic rents?  The prime example of such economic rents is the salaries paid to professional athletes, which by most standards might be viewed as excessive.  With few exceptions (Roger Staubach who became a real estate magnate and Roger Penske who became a successful Indy car owner and truck rental entrepreneur are two notable  exceptions) professional athletes earn high salaries because of a unique skill, and many would be hard pressed to earn more than a small fraction of that in their next-best job alternative.  It is unlikely that there is a unique skill to justify such rents in the financial services industry, so it is worthwhile to examine closely the role that the structure of compensation has played in the financial crisis. 

A recent NBER working paper by Rene Stultz and Rudiger Fahlenbrach carefully investigated whether the extent to which bank and investment bank CEO compensation was aligned with shareholder interests played a role in the financial crisis.  They find no support for the idea that CEOs took risks at the expense of shareholders.  What they did find was that risk taking was somewhat greater the more that CEO and shareholder interests were aligned.  They interpret this finding as evidence that perhaps  institutions were taking risks at the expense of taxpayers and the FDIC.  Other studies point out how CEO compensation is structured so that executives stand to gain more on the upside when good results are obtained than they stand to lose when bad results occur. (See for example Bebchuk, Lucian A. and Spamann, Holger, “Regulating Bankers' Pay” (October 2009). Georgetown Law Journal, forthcoming; Harvard Law and Economics Discussion Paper No. 641. Available at SSRN: http://ssrn.com/abstract=1410072.)  The studies also point out that even when bankers’ pay is aligned with shareholder interests, those interests may not be aligned with societal interests (read: moral hazard behavior may shift risks to taxpayers).  But to date there is little clear evidence of the role that executive compensation actually played in the financial crisis itself.  We do know that many key executives had substantial portions of their wealth invested in their firms, that they suffered huge financial losses when their firms failed or were forced into assisted mergers, and that most lost their jobs, status and positions (the executives of Merrill-Lynch, Bear Stearns, AIG, and Lehman Brothers are but a few examples).

Lack of evidence, however, is seemingly irrelevant when conventional wisdom is that executive pay was the problem and it is in the political interest of policy makers to “fix the problem.”  The Administration’s pay czar has already cut the salaries of the CEOs of firms receiving TARP funds and has begun to dictate the form of compensation in terms of the permissible split between base salary and incentives.  The Federal Reserve has also jumped on this bandwagon and has not only indicated it intends to play a role in the setting compensation for all banks, but also has aggressively begun to do so, even in advance of the publication of its guidelines on executive compensation.  The intention of course is to limit the incentives for “excessive risk taking.”

Here is the rub.  To limit “excessive risk taking” one first has to be able to identify it.  But isn’t this exactly what banking supervision and regulation more generally is designed to do to identify and limit “excessive risk taking” and behavior that might lead to unsafe and unsound banking?  Given the failure of banking supervisors to ensure that banks – and more specifically, large, complex banking organizations – had adequate capital to buffer the risks they were taking and were clearly caught flatfooted during the current crisis, how are we to have confidence that these same people will now suddenly be able not only to identify excessive risk taking and but also to understand how to set executive salaries to limit it?  This problem is compounded by the fact that each executive has a different inclination to take risks and will respond to compensation incentives differently.  We will need an army of psychologists to augment the bank examination staffs if the current proposals and policies go forward.  Finally, are we now expecting regulators to impose their own risk preferences and tolerances on shareholders as well, as opposed to simply truncating a bank’s operations as it approaches failure? If they don’t, we would argue that shareholders will find ways to incent their executives to take the risks they (the shareholders) desire. Otherwise, the government will effectively be running the banks.  In short, dictating the structure of individual executives’ pay is no silver bullet.

In another commentary, http://www.cumber.com/commentary.aspx?file=080709.asp, we suggested an alternative approach to executive compensation.  In more refined form here, the proposal is simply to eliminate the ability to expense bonuses and incentive pay and to require that such compensation can only be paid out of and up to the amount of positive consolidated-entity profits.  The proposed pay limits would change the internal corporate pay policies that presently enable traders and other risk takers to earn huge bonuses irrespective of the losses that might accumulate in other parts of the organization.  By adopting the proposed policy, those under incentive and bonus plans would not only have an incentive to care about subsidizing unprofitable parts of the business that would reduce the bonus pool but also they would share gains with shareholders, who would have the say on the split.  Such a plan would eliminate the asymmetric nature of current compensation plans, would be easy to implement and monitor, and would not require micro-management by government.

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