Regulating Bank Executive Pay—Addressing the Wrong Problem in the Wrong Way

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.