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Regulating Bankers' Pay

52 Pages Posted: 30 May 2009 Last revised: 8 Oct 2010

Lucian A. Bebchuk

Harvard Law School; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR) and European Corporate Governance Institute (ECGI)

Holger Spamann

Harvard Law School

Date Written: October 1, 2009

Abstract

This paper seeks to make three contributions to understanding how banks’ executive pay has produced incentives for excessive risk-taking and how such pay should be reformed. First, although there is now wide recognition that pay packages focused excessively on short-term results, we analyze a separate and critical distortion that has received little attention. Equity-based awards, coupled with the capital structure of banks, tie executives’ compensation to a highly levered bet on the value of banks’ assets. Because bank executives expect to share in any gains that might flow to common shareholders, but are insulated from losses that the realization of risks could impose on preferred shareholders, bondholders, depositors, and taxpayers, executives have incentives to give insufficient weight to the downside of risky strategies.

Second, we show that corporate governance reforms aimed at aligning the design of executive pay arrangements with the interests of banks’ common shareholders - such as advisory shareholder votes on compensation arrangements, use of restricted stock awards, and increased director oversight and independence -cannot eliminate the identified problem. In fact, the interests of common shareholders could be served by more risk-taking than is socially desirable. Accordingly, while such measures could eliminate risk-taking that is excessive even from shareholders’ point of view, they cannot be expected to prevent risk-taking that serves shareholders but is socially excessive.

Third, we develop a case for using regulation of banks’ executive pay as an important element of financial regulation. We provide a normative foundation for such pay regulation, analyze how regulators should monitor and regulate bankers’ pay, and show how pay regulation can complement and reinforce the traditional forms of financial regulation.

Keywords: executive compensation, banks, financial regulation, financial firms, financial crisis, TARP, restricted shares, options, moral hazard, risk-taking, prudential regulation, say on pay, compensation committees

JEL Classification: G28, K23

Suggested Citation

Bebchuk, Lucian A. and Spamann, Holger, Regulating Bankers' Pay (October 1, 2009). Georgetown Law Journal, Vol. 98, No. 2, pp. 247-287, 2010; Harvard Law and Economics Discussion Paper No. 641. Available at SSRN: https://ssrn.com/abstract=1410072

Lucian A. Bebchuk (Contact Author)

Harvard Law School ( email )

Cambridge, MA 02138
United States
617-495-3138 (Phone)
617-812-0554 (Fax)

HOME PAGE: http://www.law.harvard.edu/faculty/bebchuk/

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR) and European Corporate Governance Institute (ECGI)

Holger Spamann

Harvard Law School ( email )

Cambridge, MA 02138
United States

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