Executive Compensation, Director Compensation and Bank Capital Requirements Reform

Abstract

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 contributing to the current financial crisis. 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. Such an incentive compensation policy will discourage managers from undertaking high-risk investments that are value destroying; instead focus their attention on creating and sustaining long-term shareholder value.

Also, we suggest that director incentive compensation be constructed along the lines noted above. Specifically, all incentive compensation for directors should only consist of restricted equity (restricted stock and restricted stock option) - restricted in the sense that directors cannot sell the shares or exercise the options for two to four years after their last board meeting.

The above equity based incentive programs lose their effectiveness in motivating managers (and directors) to enhance shareholder value as a bank’s equity value approaches zero (as they did for the too-big-to-fail banks in 2008). Additionally, our evidence suggests that bank CEOs sell significantly greater amounts of their stock as the bank’s equity-to-capital ratio decreases. Hence, for equity based incentive structures to be effective, banks should be financed with considerable more equity than they are being financed currently. Greater equity financing of banks coupled with the above compensation structure for bank managers and directors will drastically diminish the likelihood of a bank falling into financial distress; this will effectively address the too-big-to-fail problem and the Volcker Rule implementation that are two of the more significant challenges facing the implementation of the Dodd-Frank Act.