Aligning Incentives at Systemically Important Financial Institutions: A Proposal by the Squam Lake Group

6 Pages Posted: 23 Dec 2013

See all articles by Martin N. Baily

Martin N. Baily

Brookings Institution

John Y. Campbell

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

John H. Cochrane

Hoover Institution; National Bureau of Economic Research (NBER); University of Chicago - Booth School of Business

Douglas W. Diamond

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

Darrell Duffie

Stanford University - Graduate School of Business; National Bureau of Economic Research (NBER)

Kenneth R. French

Dartmouth College - Tuck School of Business; National Bureau of Economic Research (NBER)

Anil K. Kashyap

University of Chicago, Booth School of Business; National Bureau of Economic Research (NBER); Federal Reserve Bank of Chicago

Frederic S. Mishkin

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

David S. Scharfstein

Harvard Business School - Finance Unit; National Bureau of Economic Research (NBER)

Robert J. Shiller

Yale University - Cowles Foundation; National Bureau of Economic Research (NBER); Yale University - International Center for Finance

Matthew J. Slaughter

Dartmouth College - Tuck School of Business; National Bureau of Economic Research (NBER)

Hyun Song Shin

Bank for International Settlements (BIS)

René M. Stulz

Ohio State University (OSU) - Department of Finance; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Date Written: Fall 2013

Abstract

To address the moral hazard problem that can motivate bank executives to take excessive risks and to fail to raise capital when needed, a group of 13 distinguished financial economists recommends that systemically important financial institutions be required to issue contingent convertible debt (CoCos) and to hold back a substantial share - as much as 20% - of the compensation of employees who can have a meaningful impact on the survival of the firm. This holdback should be forfeited if the firm's capital ratio falls below a specified threshold. The deferral period should be long enough - the authors suggest five years - to allow much of the uncertainty about managers' activities to be resolved before the bonds mature. Except for forfeiture, the payoff on the bonds should not depend on the firm's performance, nor should managers be permitted to hedge the risk of forfeiture. The threshold for forfeiture should be crossed well before a firm violates its regulatory capital requirements and well before its contingent convertible securities convert into equity. The Swiss Bank UBS has paid bonuses to its top 6,500 executives that have been structured in exactly this way. Management forfeits its deferred compensation if the bank's regulatory capital ratio falls below 7.5%, and its contingent convertible debt is set up to convert into equity if the bank's capital ratio falls below 5%.

Suggested Citation

Baily, Martin N. and Campbell, John Y. and Cochrane, John H. and Diamond, Douglas W. and Duffie, James Darrell and French, Kenneth R. and Kashyap, Anil K. and Mishkin, Frederic S. and Scharfstein, David S. and Shiller, Robert J. and Slaughter, Matthew J. and Shin, Hyun Song and Stulz, Rene M., Aligning Incentives at Systemically Important Financial Institutions: A Proposal by the Squam Lake Group (Fall 2013). Journal of Applied Corporate Finance, Vol. 25, Issue 4, pp. 37-40, 2013. Available at SSRN: https://ssrn.com/abstract=2371489 or http://dx.doi.org/10.1111/jacf.12040

Martin N. Baily (Contact Author)

Brookings Institution ( email )

1775 Massachusetts Ave, NW
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John Y. Campbell

Harvard University - Department of Economics ( email )

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HOME PAGE: http://scholar.harvard.edu/campbell

National Bureau of Economic Research (NBER)

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John H. Cochrane

Hoover Institution ( email )

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HOME PAGE: http://faculty.chicagobooth.edu/john.cochrane/index.htm

National Bureau of Economic Research (NBER)

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University of Chicago - Booth School of Business ( email )

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HOME PAGE: http://faculty.chicagobooth.edu/john.cochrane/research/Papers/

Douglas W. Diamond

University of Chicago - Booth School of Business ( email )

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James Darrell Duffie

Stanford University - Graduate School of Business ( email )

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National Bureau of Economic Research (NBER)

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Kenneth R. French

Dartmouth College - Tuck School of Business ( email )

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United States

National Bureau of Economic Research (NBER)

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Anil K. Kashyap

University of Chicago, Booth School of Business ( email )

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773 702-0458 (Fax)

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Federal Reserve Bank of Chicago ( email )

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Frederic S. Mishkin

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

National Bureau of Economic Research (NBER)

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David S. Scharfstein

Harvard Business School - Finance Unit ( email )

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United States
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HOME PAGE: http://www.people.hbs.edu/dscharfstein/

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Robert J. Shiller

Yale University - Cowles Foundation ( email )

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HOME PAGE: http://www.econ.yale.edu/~shiller/

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Yale University - International Center for Finance ( email )

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Matthew J. Slaughter

Dartmouth College - Tuck School of Business ( email )

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United States

National Bureau of Economic Research (NBER)

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United States

Hyun Song Shin

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

HOME PAGE: http://www.bis.org/author/hyun_song_shin.htm

Rene M. Stulz

Ohio State University (OSU) - Department of Finance ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States

HOME PAGE: http://www.cob.ohio-state.edu/fin/faculty/stulz

National Bureau of Economic Research (NBER)

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United States

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

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