The following post comes to us from Charles K. Whitehead, Professor of Law at Cornell Law School, and is based on his recent paper, “Paying for Risk: Bankers, Compensation, and Competition,” which is co-authored by Simone M. Sepe, Associate Professor of Law and Finance, University of Arizona James E. Rogers College of Law. The full paper is available here.
The financial markets have transformed in the last four decades. Greater competition among banks and non-banks across traditional business lines has benefited consumers. But at what expense?
In Paying for Risk: Bankers, Compensation, and Competition, my co-author, Simone Sepe, and I argue that the growing competition for products and services has resulted in greater competition for financial talent. In principle, that competition should align employee and employer incentives, allocating the best employees to the most profitable firms. Among banks, however, competition has had perverse results. For employees, greater risk-taking can increase short-term bank profits and, in turn, the amount the employee is paid, potentially at the expense of long-term bank value. Non-executives, therefore, have an incentive to incur significant risk upfront so long as they can depart for a new employer before any longer-term losses (and corresponding drop in pay) materialize. In short, efforts to hire the best talent have produced a negative externality: Compensation is the product of each bank’s natural interest in hiring the same employees, and since hiring is based on short-term performance, greater risk-taking is rewarded without accounting for potential longer-term losses. The result is an upward spiral in pay that limits the banks’ ability to efficiently adjust compensation to reflect risk-taking and long-term outcomes.
To date, many approaches to controlling bank risk have presumed that the financial crisis was largely caused by CEOs who failed to supervise risk-taking employees. The responses focus on executive pay, believing that executives will bring non-executives into line—using incentives to manage risk-taking—once their own pay is regulated. We argue that those responses address the wrong problem in the wrong way. As our paper describes, it was non-executive incentives, tied largely to short-term bank performance, that significantly affected bank risk-taking prior to the 2007 financial crisis; and the structure, as well as the level, of those incentives was determined largely by the market’s demand for talent, independent of executive pay. Even if executive pay is regulated, and executives act in the bank’s best interests, they will still be trapped into providing incentives that encourage risk-taking by non-executives due to the negative externality that arises from competition.
In this account of compensation and competition, banks face an informational and a coordination problem. The informational problem arises from a bank’s inability to assess an employee’s risk-adjusted results unless she remains employed long enough for the full consequences of her strategy to materialize. The coordination problem arises from each bank’s efforts to hire the same non-executives. Each bank seeks the best performers, but in doing so, it rewards employees who may choose to enhance short-term performance at the expense of increased risk-taking and longer-term losses.
We argue for three regulatory changes to address these problems. First, reflecting change in the financial markets, regulators should extend their assessment of compensation beyond individual banks to include the effect of competition on market-wide levels of pay, including the broader range of employers who now compete with banks for talent. Second, certain of a bank’s non-executives should be restricted from moving to other financial employers (including banks, insurance companies, broker-dealers, and hedge funds) for a period of time after leaving the bank, subject to defined exceptions. A mandatory “garden leave” period will increase the cost of departure, as well as permit successor employers to better assess a prospective hire’s performance, helping to balance against a non-executive’s incentives for short-term risk-taking. Third, banks should be required to include a long-term equity component in non-executive pay, with subsequent employers being restricted from compensating a new employee for any losses she incurs related to her prior work. We also discuss the value of a mandatory compensation cap that is more robust than the measure proposed in the European Union.