Getting Incentives Right: Is Deferred Bank Executive Compensation Sufficient?
University of Colorado at Boulder - Department of Finance
Brian J. Bolton
Portland State University - School of Business Administration
Yale Law School; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)
February 2, 2014
European Corporate Governance Institute (ECGI) - Law Working Paper No. 241/2014
Yale Law & Economics Research Paper No. 489
In the wake of the global financial crisis, attention has often focused on whether incentives generated by bank executives’ compensation programs led to excessive risk-taking. Post-crisis, compensation reform proposals have taken broadly three approaches: long-term deferred equity incentive compensation, mandatory bonus clawbacks upon accounting restatements and financial losses, and debt-based compensation. In earlier articles we recommended the following compensation structure for bank executives: incentive compensation should consist only 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 his or her last day in office. We contend that this incentive compensation package, which we term the Restricted Equity proposal, will focus bank managers’ attention on the long-run and discourage them from investing in high-risk, value-destroying projects. Equity based incentive programs such as our proposal may lose effectiveness in motivating managers to enhance shareholder value as a bank’s equity value approaches zero. As a consequence, some commentators have called for pay packages linked to bank debt. We contend, however, that the more appropriate approach is to retain equity-based incentive pay and to reform bank capital structure to reduce the probability of a tail event, and hence insolvency. We advance two approaches, not necessarily exclusive, that coupled with the Restricted Equity proposal, we maintain, would incentivize bank executives to not take on projects of excessive risk: meaningful higher and simpler capital requirements and mandatory issuance of contingent convertible capital – debt that converts to equity under specified adverse states of the world. Because the optimal capital level is unknown, we further advocate facilitating regulatory diversity within the international financial regulatory regime, to generate information concerning what level and form of capital works best, which would improve the quality of decision-making and the resiliency of the global financial system.
Number of Pages in PDF File: 70
Keywords: executive compensation, restricted stock, financial institution regulation
JEL Classification: G21, G28, G30, G38, K22
Date posted: February 15, 2014 ; Last revised: March 4, 2014