Should_U.S._Government_Regulate_the_Compensation_of_Senior_Bank_Executives_

The agency problems are prevalent in most commercial banks and play an important role because of many reasons, among which are the specifics of bank operations and capital structure, high leverage, easily manipulated accounting measures and weak market of corporate control. Banks commonly use incentive compensation as the main tool to prevent such problems, which became a crucial mechanism of corporate governance. Today relatively high compensation of U.S. bank CEOs and its sensitivity to bank’s performance is debated in government and financial press. Critics of performance-based pay argue that excessive risk-taking caused by alignment of interests of top managers with those of shareholders, timing of bonuses and equity option grants have contributed a lot to recent crisis, affected banks’ performance, and initiated social concerns. They also suggest that stricter regulation of top manager’s compensation should be adopted. However, intervention of government authorities in designing CEOs’ compensation may not necessarily be effective, because banks may better understand their internal problems, risk and other characteristics that determine optimal compensation schemes. As governments play a role of monitoring, it is important to understand if this monitoring substitutes or complements other mechanisms of corporate governance in banks. For instance, John and Qian (2003) suggest that by understanding the interaction of regulation and corporate governance, it is possible to gain insight into the optimal design and degree of regulation by governments. Although today’s issues in banking industry has raised the question of compensation regulation, too much intervention by government cannot actually solve the problem of excessive risk taking entirely, because banks, for example, may find another ways to avoid the law in order to attract valuable employees. Furthermore, regulation can at some point exacerbate agency problems and other issues in banks. The present essay is mainly focused on the structure of compensation of bank executives in the U.S. banks, but the amount of compensation (especially bonuses) is also mentioned. Generally, bank executive’s compensation consists of fixed salary, bonuses, equity ownership and stock option grants. Last three components of the compensation are aimed to incentivise top managers and align their interests with those of shareholders. The use of incentive compensation has increased in the last 15 years after deregulation of U.S. banking industry, the majority of CEO compensation for 95 US banks at the end of 2006 stems from performance-based pay, as the average base salary of 760,000 is less than 10% of the average total compensation (Fahlenbrach and Stulz, 2009). Stock ownership by executives do not entail increased risk-taking, instead it leads CEOs to be more risk averse than diversified shareholders, because failure of the bank might impose significant personal costs on bank’ managers as ownership of common shares represents a substantial fraction of his/her wealth (Bebchuk and Spamann, 2009). Option pay, however, pushes executives in the opposite direction. With options, executives have even more incentives for risk-taking than the common shareholders, because the value of stock options increases with volatility of stock price (i.e. risk). Moreover, government guaranties of bank liabilities additionally serves to intensify bankers’ risk taking incentives. In such situation, debtholders (depositors) have no incentives to monitor and limit excessive risk taking actions by bank executives, therefore, it might be suggested that governments should intervene. Critics of incentive compensation of bank CEOs argue that governments should regulate compensation because banks play an important role in the economy and excessive risk taking and mismanagement problems can affect the economy as a whole. Firstly, recent government support of banks (Troubled Asset Relief Program) suggests that taxpayers pay for this excessive risk-taking by bank managers. This reflects the FDIC (Federal Deposit Insurance Company) hypothesis, which predicts that shareholders of highly leveraged banks use pay-performance schemes to encourage risk taking by managers to transfer wealth to shareholders from the FDIC and taxpayers (Crawford, Ezzell and Miles, 1995). However, there is no supportive evidence to this hypothesis. Secondly, some studies present evidence to support the hypothesis that managers time bonuses and option grants prior to the release of good news. But recent huge losses of many large banks affected the wealth of top managers; in fact they also have lost millions of dollars, which suggests that many top managers were unaware of imminent threat. Study by Fahlenbrach and Stulz (2009) shows that before crisis executives were focused on the interests of their shareholders and took actions that they believed were best, but poor results ex post were not expected by the CEOs to the extent that they did not reduce or hedge their holdings of shares in anticipation of poor outcomes. These outcomes are not evidence of CEOs acting in their own interest at the expense of shareholder wealth. Thirdly, it is also possible that principal may be too forgiving, paying rewards that were not really earned. For example, the compensation committee of a board of directors may reward the CEO handsomely despite the firm’s miserable performance because they feel more loyalty to the CEO than to the shareholders. Once again, however, there is no empirical evidence in support of this view. In contrast to previous arguments, some researchers report that compensation policies are not designed to promote excessive risk taking in banking, and thus, attempts by regulators to control compensation in banking are likely to be ineffective (Houston and James, 1995). And even despite the evidence provided by recent study of DeYoung et al (2010), showing that incentives in executive compensation contracts in U.S. banks during 1990s and 2000s actually led to excessive risk-taking and mismanagement, the authors also suggest that government intervention will not necessarily be effective. The terms of optimal incentives are likely to vary substantially across firms and CEOs, while government prescriptions almost by necessity tend to be one-size-fits-all. Contractual incentives imposed via regulation are by implication aimed at providing public goods (i.e. financial market stability, fairness) and could work far differently than contractual incentives designed by boards to mitigate principal-agent problems. Results of studies by Belkhir and Chazi (2008) of U.S. bank holding companies over the 1993-2006 period suggest that even in the presence of high executives’ incentives to increase risk, risk-taking is limited by other factors. In other words, bank CEOs limit themselves to a certain level of risk even if they have very high incentives to take on high risks. Banks might better perceive the effect of these other factors, risk characteristics, etc. and thus, make better decisions about compensation structure. Banks definitely better understand the incentives of their employees and design the compensation by balancing incentives and risk bearing of top managers. Today many banks take sensible measures to alter and adjust their compensation schemes in the face of crisis. Further, to the extent that the market for a bank’s stock is efficient, changes in a bank’s long-term performance will be properly reflected in the stock price. Thus, greater sensitivity of a CEO’s wealth to his bank’s stock price will make it advantageous for the CEO to improve his bank’s long-term performance when it makes economic sense to do so. Focusing on the short run rather than the long run would be costly for CEOs since their stock price would be lower than if they had taken actions to maximize shareholder wealth. Also, since pay structures during the boom looked rather similar across Wall Street, and senior executives all have sizeable shareholdings in the banks they run, compensation also does little to explain the differences between those institutions that have done well during the crisis and those that have not (The Economist, Make them Pay, 17 May 2008). This fact is contrary to the opinion that compensation structure and amount contributed to problems in banking industry. In addition, restricting pay levels of chief executive officers reduces the effectiveness of a well-functioning managerial labour market and its associated pay structure in attracting talented managers to challenging careers (Hubbard and Palia, 1995). Making dramatic changes to compensation structures involves a prisoner's dilemma. Although it might benefit everyone in the industry to reduce bonuses, better pay attracts better people. Low bonus payments may drive away the talented executives needed to bring the banks back to profitability. Moreover, fixed limits on bonuses are likely to lead to higher guaranteed salaries, in fact, such increases in base salaries has already happened in banks receiving TARP support. Finally, reputation effect can prevent bank CEOs from investing in too risky projects and pursuing their own interests. For some executives Money may not be as important as it seems: many in the industry are far more motivated by the desire to outshine their peers. Considering all the issues discussed above, it is obvious that tough government control may not play an important role. U.S. government has already taken some measures to regulate executive pay, but further right to adjust compensation structure and amount should be given to banks. Government policies sometimes contradict their main purposes such as providing economic prosperity and development, because some of them (e.g. deposit insurance) ultimately make executives to invest in highly risky projects, which in turn can end up sadly for all parties, especially for society. It may be better for government to prevent such situations than dealing with them when the problems have already occurred. There are enough corporate governance tools that banks can use to prevent unfavourable effects caused by compensation design. Even if government adopts strict regulation, banks will find another ways to maintain their own policies. Therefore, government regulation should be balanced with the freedom of banks in deciding what is the really best for them given each bank’s specific characteristics. The rules of free market will definitely arrange everything back to order. As Harry Browne once said: "The free market punishes irresponsibility. Government rewards it."