Financial Crisis, Corporate Governance, and Bank Capital

Abstract

While some have argued that incentives generated by executive compensation programs led to excessive risk-taking by banks contributing to the 2008 financial crisis, there are more important causes of the financial crisis of 2008. Specifically, public policies regarding home mortgages are perhaps the single most important cause of the financial crisis of 2008. As is the case with most public policies, the intent of public policies regarding home mortgages was honorable – its goal was to increase home ownership by those who could not otherwise afford home mortgages. However, these public policies also encouraged an incentive compensation structure in the big banks focused on generating short-term profits at the cost of large longer-term losses.

We find that incentives generated by bank executives’ compensation programs contributed to excessive risk taking. To address these misaligned incentives, we recommend 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 one to three years after his or her last day in office. We contend that this incentive compensation package will focus bank managers’ attention on the long run and discourage them from investing in high-risk, value-destroying projects. We discuss and provide solutions to many of the caveats that arise, specifically regarding under-diversification and loss of liquidity.

Our recommendation for executive (and director) compensation is based on our analysis of compensation structure in banks. The aforementioned 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 capital (tangible common-stock-to-total-assets ratio) decreases. Hence, for equity-based incentive structures to be effective, banks should be financed with considerably more equity than they are being financed currently. Specifically, bank equity capital should be, at least, 20% of bank total assets; we recommend against any risk-weighting of bank total assets, and including both on-balance sheet and off-balance sheet items in total assets. Our proposal is consistent with the spirit of the CHOICE Act recently approved by the U.S. House of Representatives.

Greater equity financing of banks coupled with the aforementioned 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 important provisions of the Dodd-Frank Act.

Keywords: CHOICE Act, Dodd-Frank, financial crisis, bank capital, bank governance, executive compensation, director compensation

JEL Classification: G01, G21, G28, G34, G3