Rethinking “Strength of Incentives” for Executives of Financial Institutions

Abstract

The recent crisis has caused some finance theorists and practitioners to rethink the effects of managerial incentives on the total enterprise value of large financial institutions. This re-examination has identified and analyzed a number of potential problems with the use of equity-based compensation, including insufficiently long managerial time horizons as well as the temptation for excessive risk-taking provided by “asymmetric” payoff structures in which shareholders have virtually all the upside while debtholders bear most of the downside risk. In an attempt to address such problems, finance and governance scholars have increasingly explored the possible value of aligning managerial interests with those of not only shareholders, but other important corporate claimants such as debtholders and taxpayers. After reviewing the latest thinking about risk and managerial incentives at financial institutions, the authors come to the following conclusions: • The design of incentives for value maximization needs to reflect a healthy appreciation of downside risk as well as upside reward, and both senior and subordinated debt may be ideal instruments for establishing that balance. At the same time, most senior executives should continue to receive equity-linked compensation in addition to significant proportions of “inside debt.” • Since decision-makers below the highest level executives of large financial institutions collectively wield enormous power to assume and manage risks, this “upper-middle” tier of managers deserves special attention. Rather than rewarding these managers with stock or options, the authors suggest use of a combination of uncapped but “held-at-risk” bonuses denominated in subordinated inside debt as the best way of rewarding effort and competence while controlling opportunities for risk-shifting.