The 2007-2009 Financial Crisis and Executive Compensation: An Analysis and a Proposal for a Novel Structure

Abstract

During the 2007-2009 crises financial institutions have come under increasing pressure from regulators, politicians and shareholders to change their compensation practices in order to remove the incentive for short term excessive risk taking.

In this paper we analyze how commonly used executive compensation plans can lead to two socially undesirable outcomes: excessive risk taking at one extreme and complete freeze of new lending on the other. We propose adding a new component to the executive compensation which is paid only if the value of the firm will be located in some predetermined range. This components will push the executive towards the first best solution in which an intermediate (internal solution) level of assets risk will be optimal because of the convex relationship between assets risk and compensation value.

Keywords: compensation practices, executive compensation, excessive risk taking, executive stock options, financial crisis

JEL Classification: G12, G13, G21, G28, G38, E58