49 Pages Posted: 25 Aug 2010
Date Written: August 24, 2010
We study the executive compensation structure in the largest 14 U.S. financial institutions during 2000-2008. Our results are mostly consistent with and supportive of the findings of Bebchuk, Cohen and Spamann (2010), that is, managerial incentives matter - incentives generated by executive compensation programs led to excessive risk-taking by banks leading to the current financial crisis. Also, our results are generally not supportive of the conclusions of Fahlenbrach and Stulz (2009) that the poor performance of banks during the crisis was the result of unforeseen risk.
We recommend the following compensation structure for senior bank executives: Executive incentive compensation should only consist of restricted stock and restricted stock options – restricted in the sense that the executive cannot sell the shares or exercise the options for two to four years after their last day in office. However, managers should be permitted to annually liquidate about 5% to 15% of their ownership positions, but these annual ownership position liquidations should be restricted to an amount of $5 million to $10 million. This compensation structure will provide managers stronger incentives to work in the interests of long-term shareholders, and avoid excessive risk-taking.
While our focus here is on banks, corporate board compensation committees of firms in other industries should also give the above executive incentive compensation structure serious consideration. Additionally, we suggest that directors should adopt a similar incentive compensation structure with regard to their own incentive compensation.
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By Kevin Murphy