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July 25, 2011

Should bank CEOs be compensated with debt, cash, or stock?

Posted by David Zaring

This post will not break new ground but one wants to have a sense about how current executive compensation debates are playing out. Here's one way to look at it from the outside:

Conventionally executives were compensated with cash, and not much of it, until three decades ago, when it was argued, based in part on academic scholarship, that stock compensation would align the interests of the executives with those of the shareholders.
Stock does align the interests of executives with stockholders. But that interest could be short term. For financial institutions, the biggest worry is that the executives might retire and sell everything just as the bank was about to suffer a deterioration in its safety or soundness.
Options that vest at some point in the distant future do not have this problem.
But nor do bonds issued by the banks, which will presumably pay out unless the bank goes under. Compensating executives with 10 year or even 30 years bonds would presumably have them much more worried about the killer credit event (even if they started ignoring the short term interests of stockholders).
And of course, for whatever reason, the turn to options compensation was correlated with an explosion in the size of compensation more generally.
I'm not yet convinced by the usefulness of compensation for bank CEOs through bank bonds. For one thing, banks do not often go bust, which means that the risk taking that would be curbed would be pretty outer bounds risk. For another, banks that have to go raise equity or go under dilute the value of options and stock, so CEOs have that to think about as well. Finally, despite the Kuhnian change in executive compensation that option grants represented, I have a Burkean skepticism of novel kinds of compensation that few (very few?) companies currently use.
Let's leave the partnership model of the Wall Street investment banks aside for now. Ditto subordinated debt or preferred stock. But let me know if you think I'm missing alternatives in the palette for compensation design among which shareholders and regulators may choose.

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This post will not break new ground but one wants to have a sense about how current executive compensation debates are playing out. Here's one way to look at it from the outside:

Conventionally executives were compensated with cash, and not much of it, until three decades ago, when it was argued, based in part on academic scholarship, that stock compensation would align the interests of the executives with those of the shareholders.
Stock does align the interests of executives with stockholders. But that interest could be short term. For financial institutions, the biggest worry is that the executives might retire and sell everything just as the bank was about to suffer a deterioration in its safety or soundness.
Options that vest at some point in the distant future do not have this problem.
But nor do bonds issued by the banks, which will presumably pay out unless the bank goes under. Compensating executives with 10 year or even 30 years bonds would presumably have them much more worried about the killer credit event (even if they started ignoring the short term interests of stockholders).
And of course, for whatever reason, the turn to options compensation was correlated with an explosion in the size of compensation more generally.
I'm not yet convinced by the usefulness of compensation for bank CEOs through bank bonds. For one thing, banks do not often go bust, which means that the risk taking that would be curbed would be pretty outer bounds risk. For another, banks that have to go raise equity or go under dilute the value of options and stock, so CEOs have that to think about as well. Finally, despite the Kuhnian change in executive compensation that option grants represented, I have a Burkean skepticism of novel kinds of compensation that few (very few?) companies currently use.
Let's leave the partnership model of the Wall Street investment banks aside for now. Ditto subordinated debt or preferred stock. But let me know if you think I'm missing alternatives in the palette for compensation design among which shareholders and regulators may choose.

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