Thoughts on How Bank Executive Compensation Should Be Reformed

Thoughts on How Bank Executive Compensation Should Be Reformed
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Senior bank regulators are considering new regulations on bank executive pay. Bank regulators and boards should consider three criteria to evaluate bank executive compensation reform policies: simplicity, transparency, and a focus on creating and sustaining long-term shareholder value. As shareholders are now required to vote on CEO compensation packages, a simple incentive structure is easier for them to understand and evaluate, reducing the need to rely on third-party vendors of proxy voting advice, the value of which has been the subject of considerable controversy. Second, simplicity and transparency in incentive compensation packages mitigate public skepticism toward high levels of executive pay in conjunction with poor performance. Third, there is no empirical evidence that complexity of CEO pay is positively related to future accounting or share-price performance. Instead, complexity has led to increased earnings manipulation by managers. Finally, focusing on creating and sustaining long-term shareholder value would channel management’s attention to the longer term profitability. Business and legal scholars posit that managers should act in the best interest of long-term shareholders. What better way to do this than tie management incentive compensation to long-term share price?

We propose that the incentive compensation of senior corporate executives should consist only of restricted equity (i.e., restricted stock and restricted stock options). That is, restricted in the sense that the individual cannot sell the shares or exercise the options for one to three years after their last day in office.

The incentives generated by this restricted equity compensation plan structure would be relevant for maximizing long-term shareholder value. For example, consider the cases of Enron, WorldCom, Qwest, many of the big-banks circa 2007-2008, and Wells Fargo more recently.  Senior executives in these companies made misleading public statements regarding the earnings of their respective companies. These misleading statements led to a temporary rise in the share prices of these companies. These executives liquidated significant amounts of their equity positions during the period while their companies’ share price was temporarily inflated. If these executives’ incentive compensation had consisted of only restricted stock and restricted stock options that they could not liquidate for one to three years after their last day in office, they would not have had the financial incentive to make the abovementioned misleading statements.

Under this restricted equity compensation plan, all incentive compensation would be driven by total shareholder return instead of being directly related to accounting-based measures of performance such as return on capital, return on equity, or earnings per share. Accounting-based measures of performance tend to mostly focus on short-term performance.

While the specific time horizon is ultimately the compensation committee’s decision, ideally, that time frame would extend one to three years after the executive’s departure. The rationale for this extended time frame is to maintain incentives for an executive in an “end-game” situation, i.e., an individual making decisions when he or she is reaching retirement. At the shorter end of this suggested time horizon, management’s discretionary authority to manage earnings under current U.S. accounting conventions unravels within a one- to two-year period, while at the longer end we think three years is a reasonable period in which at least the intermediate-term results of executives’ decisions will be realized.

The median tenure for S&P 500 CEOs is between five and seven years. In the private company setting, it is common for top executives to wait six to ten years before receiving a substantial portion of their compensation for work performed earlier. For instance, the general partners of private equity partnerships typically receive their compensation towards the end of the life of the partnership, usually seven to ten years. The widespread use of a deferred compensation structure in a real-world setting where manager-owner conflicts of interest are thought to be better managed suggests that this proposal could substantially improve managers’ incentives, despite well-known differences between the private equity and public company operating environments.

A further benefit of using a one- to three-year post-departure vesting period is that, because a CEO would be exposed to the impact of decisions made by his or her successor, the executive will focus more attentively on succession planning.

Clawback provisions such as those in Dodd-Frank are not as effective an incentive mechanism as our proposal noted above. They are inherently difficult to compute (e.g., it is unclear how to calculate the Dodd-Frank clawback measure when the award was not based on an accounting target), and entail uncertain litigation costs. Our proposal has an inherent clawback (and, deferral and forfeiture) feature that renders unnecessary intricate mechanisms requiring repayments (forfeiture) of bonuses on income from transactions whose value proved illusory. Because executives are compensated in equity that is not received until years after it is earned – one to three years after they leave the firm – they cannot capture short-lived share price gains from transactions whose value is not long-lasting. The compensation will be dissipated as the value of the firm’s shares decline upon the realization of the project’s or investment strategy’s losses.

There are three important concerns with this compensation plan structure. First, if executives are required to hold restricted shares and options, they would most likely be under-diversified. Second, if executives are required to hold restricted shares and options post-retirement, they may be concerned with lack of liquidity. Third, this kind of a compensation plan could lead to early managerial departures as executives seek to convert illiquid shares and options into more liquid assets after the one- to three-year waiting period.

The deliberate under-diversification brought about by being subject to a restricted equity plan would lower the risk-adjusted expected return for the executive. One means of bringing an executive’s risk-adjusted expected return back up to the previous level would be to increase the expected return by granting additional restricted shares and options to the executive. As a result, the amount of equity awarded under the above plan will be higher than that awarded under a short-term incentive plan.

Concerns regarding lack of liquidity and early departure are also valid. To address these concerns, we recommend managers should be allowed to annually liquidate 5 percent to 10 percent of their awarded incentive restricted shares and options. The requirement that they must retain the majority of the shares for several years after retirement or departure will provide sufficient incentive to advance long-term shareholder interests, and eliminate the need for future tax-payer funded bailouts.

Finally, one size does not fit all. Bank boards need to use their understanding of the unique circumstances of their bank’s opportunities and challenges to amend the restricted equity plan. In implementing the proposal, bank boards should be the principal decision-makers regarding:

·       The mix of restricted stock and restricted stock options a manager is awarded.

·       The amount of restricted stock and restricted stock options the manager is awarded.

·       The maximum percentage of holdings the manager can liquidate annually.

·       Number of years post retirement/resignation for the stock and options to vest.

Sanjai Bhagat is the Provost Professor of Finance at the University of Colorado, Boulder, and author of Financial Crisis, Corporate Governance and Bank Capital.

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