You know a corporate law issue is hot if it is hotly debated around our Holiday table. Try as I could, I found it hard to mount a successful defense of current levels of executive compensation. (The only person who bought my arguments was my 19 year old cousin who wants a summer job at Goldman Sachs). But is it just the obscene level of compensation and income disparity that bothers us? One relative – let’s call her “mom” – said that executive compensation caused the financial crisis. Yet the precise link between executive compensation and the financial crisis is not easy to articulate. Raghuram Rajan has been rightly lauded for sounding a warning for the crisis with his 2005 article Has Financial Development Made the World Riskier? In that article, Rajan focused on the skewed incentives that investment managers had to take risky bets by enjoying the upside but not the downside of investments. His analysis is still compelling.
Yet re-reading Rajan also leads me to believe that some of the broader strokes of Dodd-Frank dealing with executive compensation, such as say on pay, may be too broad. If we are justifying regulating compensation because of the crisis, it seems odd to sweep in non-financial firms. What, after all, does the pay of executives at Intel, Google, Boeing, or Exxon Mobil have to do with the financial crisis? Say-on-pay and other Dodd-Frank reforms that apply to a broad swath of non-financial firms need to be justified on their own merits and not with an invocation of crisis spirits.
On the other hand, financial firms are fundamentally different beasts. We cannot stop with the standard analysis of agency costs that applies to the compensation arrangements at generic companies. The capacity of financial firms to externalize the costs of their risk-taking on the credit markets and the economy as a whole argues for additional scrutiny. The principal Federal bank regulators made this point in June 2010 guidance on compensation policies at banks. They wrote, “Aligning the interests of shareholders and employees, however, is not always sufficient to protect the safety and soundness of a banking organization.” The regulators argued that the presence of a federal safety net meant that shareholders may not care enough about whether a bank’s compensation policies encourage excessive risk. This argument could be taken a step further as the failure of firms, like Lehman, that did not receive a federal lifeline still caused massive economic damage. Financial firms need to be treated differently. Moreover, the agency cost rubric for looking at compensation that applies to most firms – does compensation align management and shareholder interests – may produce perverse results if applied to financial firms. Leo Strine of the Delaware Court of Chancery makes a case that further aligning manager interests with those of shareholders might further encourage short-termism – including high-reward-today-high-risk-tomorrow investments. This argument becomes stronger when applied to financial institutions.
If much of Dodd-Frank’s compensation focus is thus too broad, much of it is also too narrow. The compensation of non-executives – from traders at a Bear Stearns trading desk to mortgage brokers earning six figure incomes at Countrywide – may explain more of the perverse risk-taking in the crisis than the pay of ceos at those firms. Indeed, many of the most prominent ceos pilloried after the crisis – Cayne, Mozilo, Fuld – actually lost a significant chunk of their personal fortunes as their firms foundered. (See Fahlenbrach & Stulz for a more rigorous analysis).
If compensation – executive and non-executive -- at financial institutions is more directly connected to the crisis, then banking regulation offers a better toolbox for addressing skewed incentives for taking excessive risk produced by bad compensation arrangements. But which tool in that toolbox is worth applying? The June 2010 Guidance from the Federal Reserve/OCC/OTS/FDIC mentioned above offers one approach, namely making compensation arrangements a key part of the examination of the safety and soundness of federally regulated financial institutions.
Even so, a great deal of skepticism is in order over whether this guidance for bank examiners will have a meaningful effect. Two concerns stand out. First, this guidance just adds to the already voluminous standards that examiners must consider in evaluating safety and soundness. Voluminous is a severe understatement; as part of my research into risk models I downloaded Federal Reserve and FDIC examination manuals. The material took over three flash drives. There is no way even Hercules (the Ronald Dworkin version) could read, let alone actually apply all of those standards. Will compensation just get lost in the weeds?
Second, what is the both intellectual and regulatory framework for identifying and promoting good compensation arrangements? The June 2010 Guidance gets the conceptual issues with executive compensation right – albeit on a very high level of abstraction: making sure that all bank employees, not just executives, have balanced incentives for risk-taking. This would include ensuring that employees feel the downside pain and not just the upside gain of credit and investment decisions. But what does this mean in practice? And what standard would apply to banks? Here, the regulators, with a mix of wisdom and cowardice, resort to a principles-based approach and eschew setting concrete standards.
There are obvious benefits to remaining general but big drawbacks as well. Where is the certainty for banks and their counsel? Will this standard just be yet another blurry aspirational standard that just hides the naughty bits of banks and regulators?
So the jury is out on whether bank regulators “get” compensation and whether it will translate into flexible, but durable regulation. The issue is worth studying and monitoring closely, because looking at compensation offers one of the most cogent ways of addressing financial institution risk-taking. I am a proponent of simpler regulatory approaches that address overall incentives of actors as opposed to micromanaging processes. Ensuring appropriate compensation structures for financial institution employees means we don’t have to get lost in the weeds of determining how much risk is too much. As a case in point, I spent a good part of Wednesday reading through proposed Federal rules on capital requirements for market risk. Asked to comment on the rules, I found myself at a loss to say whether the agencies’ technocratic fixes to regulating bank risk models made any sense at all. Who knows if the regulators are requiring adequate adjustments to VaR for correlation trading positions? I had the sinking feeling that agencies may not see the risk they face of again getting inextricably tangled in the technocratic underbrush.
My wish is that one year I’ll be sitting around a Gerding family table in November and December and will be able to share the raucous good news that bank regulators are doing a good job with compensation. It may not satisfy mom, but it if keeps my Wall-Street-bound cousin from crashing the economy that would do just fine.
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