Pay for Banker Performance: Structuring Executive Compensation for Risk Regulation

Abstract

Excessive risk taking by firm managers did not originate with the Financial Crisis of 2007-08. Though bankers had special incentives to take big risks in the period before the Crisis, the incentive effects of equity-based compensation have been understood for some time. Among other things, equity compensation tends to induce greater risk taking by aligning managers’ risk preferences with those of equity holders. Longstanding government guaranties of bank liabilities additionally served to intensify bankers’ risk taking incentives. I propose to ameliorate this gambler’s incentive with a new approach to compensation at the largest banks, one that explicitly accounts for the possibility of excessive risk taking and incentivizes bankers against it. I propose that bankers be paid in part with their banks’ public subordinated debt securities. Market pricing of this debt will be particularly sensitive to downside risk at the bank. Including it in bankers’ pay arrangements and personal portfolios will therefore give bankers direct personal incentives to avoid excessive risk. Moreover, recent theoretical and empirical research suggests that as CEOs’ holdings of their firms’ debt increases, firm risk taking declines. My approach has important advantages over recent banker pay reform proposals. The largest banks are owned and operated as wholly-owned subsidiaries of bank holding companies (BHCs), which also typically own other financial institutions. Two proposals - one by Lucian Bebchuk and Holger Spamann, and another by Sanjai Bhagat and Roberta Romano - would compensate bankers with BHC securities. But because BHCs own other institutions besides the given banking subsidiary, BHC securities can offer bankers only noisy and indirect incentives with respect to risk taking at the bank. My approach overcomes this problem by paying bankers with debt securities issued by the bank itself, a course unavailable with these other proposals. Debt securities of the bank will be much more sensitive to downside risk at the bank than the BHC equity and other securities that are the focus of these other proposals. In addition, my proposal offers sufficient flexibility to enable the tailoring of banker pay to account for bankers’ existing portfolios of their firms’ securities and other claims on their firms. Because these portfolios typically dwarf bankers’ annual pay, they exert much stronger influence on banker risk taking than does annual pay. Compensation should therefore be structured primarily with these portfolio incentives in mind. My approach facilitates the tailoring of annual pay to achieve desirable portfolio incentives for bankers in a way that existing proposals cannot.