Executive Compensation Executive Compensation and Public Policy*and Public Policy*

Lemma W. SenbetLemma W. SenbetUniversity of MarylandUniversity of Maryland

Keynote SpeechKeynote SpeechTriple Crown ConferenceTriple Crown ConferenceNewark, April 30, 2010Newark, April 30, 2010

Two Landmark Episodes Two Landmark Episodes of the Last Decadeof the Last Decade

•• The burst of the The burst of the information technology boominformation technology boom and the and the ensuing massive corporate scandals triggered ensuing massive corporate scandals triggered

Collapse of wellCollapse of well--known companies (e.g., Enron, known companies (e.g., Enron, WorldCom)WorldCom)Massive destruction of shareholder wealthMassive destruction of shareholder wealthDamage to other stockholders.Damage to other stockholders.

•• The burst of the The burst of the housing bubblehousing bubble and the subprime debacle and the subprime debacle lead to:lead to:

Shut down of the credit marketsShut down of the credit marketsFailure of venerable financial institutions (e.g., Lehman Failure of venerable financial institutions (e.g., Lehman Brothers, Merrill Lynch, AIG, etc.).Brothers, Merrill Lynch, AIG, etc.).

•• The Great Financial Crisis has spread around the world. The Great Financial Crisis has spread around the world.

Executive Compensation and the Executive Compensation and the Landmark EpisodesLandmark Episodes

The two landmark events have drawn The two landmark events have drawn attention to the high attention to the high levelslevels of executive of executive pay and to the pay and to the structurestructure of these pay of these pay plans.plans.A particular question:A particular question: Have illHave ill--designed designed compensation plans contributed to the compensation plans contributed to the scandals surrounding the technology scandals surrounding the technology bubble bubble andand the current global financial the current global financial crisis? crisis?

Policy ResponsesPolicy ResponsesPublic responses to both episodes have been commensurately Public responses to both episodes have been commensurately dramatic. dramatic. The corporate scandals gave rise to various regulatory and The corporate scandals gave rise to various regulatory and governance reforms, with an advent of the landmark Act governance reforms, with an advent of the landmark Act [The [The SarbanesSarbanes--Oxley Act, 2002]. Oxley Act, 2002]. The The Great Financial CrisisGreat Financial Crisis has resulted in government has resulted in government bailouts of a scope unseen since the bailouts of a scope unseen since the Great Depression.Great Depression.The global financial crisis has generated extensive debate on The global financial crisis has generated extensive debate on the role of executive pay in the propagation of the crisis.the role of executive pay in the propagation of the crisis.•• Executive pay at our largest financial services companies featurExecutive pay at our largest financial services companies feature e

prominently in the debate about financial policy reform. prominently in the debate about financial policy reform. •• The advent of Pay CzarThe advent of Pay Czar•• House has already approved a reform on pay (HR 3269). House has already approved a reform on pay (HR 3269).

NextNext

Discuss the key issues pertaining to the debate Discuss the key issues pertaining to the debate on executive payon executive payDiscuss key reform proposalsDiscuss key reform proposals•• Provide academic rationale for these Provide academic rationale for these

proposalsproposals•• Provide arguments on both sides of the Provide arguments on both sides of the

debatedebateRole of executive pay in current crisisRole of executive pay in current crisis•• Propagation of crisis and prevention of crisisPropagation of crisis and prevention of crisis

Case for incentivized regulation Case for incentivized regulation

Core IssuesCore IssuesIs executive pay sufficiently linked to longIs executive pay sufficiently linked to long--term corporate term corporate performance?performance?•• Cases where executive pay at certain companies rose Cases where executive pay at certain companies rose

dramatically even though companies were doing poorly and dramatically even though companies were doing poorly and stock prices plummetingstock prices plummeting

Is executive pay excessive?Is executive pay excessive?•• Beyond what is required to retain and motivate executivesBeyond what is required to retain and motivate executives

Does executive pay provide incentives to Does executive pay provide incentives to performperform or incentive or incentive to to manipulatemanipulate performance?performance?•• Overly generous packages with largeOverly generous packages with large--sized stock option sized stock option

grants may have created incentives to manipulate financial grants may have created incentives to manipulate financial statements to drive up stock pricestatements to drive up stock price

•• Contributing to the corporate scandals of the postContributing to the corporate scandals of the post--dot come dot come era and the current financial crisisera and the current financial crisis

A Perspective on Financial CrisisA Perspective on Financial CrisisExcesses and Collateral DamageExcesses and Collateral DamageHousing boom and mortgage boomHousing boom and mortgage boom

•• Globalization of the US housing through MBS Globalization of the US housing through MBS

Complex and opaque securitizationComplex and opaque securitizationRating agencies and grade inflationRating agencies and grade inflationEasy money and global imbalanceEasy money and global imbalanceExcessive leverage (banks/shadow banks)Excessive leverage (banks/shadow banks)

•• Explicit and implicit insurance (TBTF)Explicit and implicit insurance (TBTF)•• Excessive riskExcessive risk--takingtaking

Role of executive pay?Role of executive pay?

Complexity Through TranchingComplexity Through Tranching

Homes Mortgages Mortgage Tranched Tranches Equity

Human Capital Owed Pools securities held Deposits

Households Sponsored SPV Debt investors

Where Does Executive Pay Fit in Where Does Executive Pay Fit in this Debate?this Debate?

The The sizesize of the pay packages of employees at the of the pay packages of employees at the failed institutions has been a source of outrage.failed institutions has been a source of outrage.•• The $165 million AIG bonus The $165 million AIG bonus and and large bonuses large bonuses

for Merrill Lynch employees around the Bank of for Merrill Lynch employees around the Bank of America takeoverAmerica takeover

However, comparatively less attention to However, comparatively less attention to structurestructure of of pay and pay and processprocess of setting payof setting payWhat is the interaction between What is the interaction between ““excessiveexcessive”” leverage leverage and high powered incentives in compensation?and high powered incentives in compensation?Should the right compensation structure be the Should the right compensation structure be the one that aligns executives in the financial one that aligns executives in the financial services industry with the shareholders?services industry with the shareholders?

CorpOther Stakeholders

(Product/Labor Markets)

Equity holders

Government/SocietyDebt

holders

Classes of Agency

Excessive PerquisitesExcessive risk-taking

Risk conservatismUnder/Overinvestment

Asymmetric InformationBankruptcy/ Financial Distress

Management

Executives

Board of Directors

Executive CompensationExecutive CompensationGood and Dark Side: Agency PerspectiveGood and Dark Side: Agency Perspective

Executive CompensationExecutive CompensationGood SideGood Side

Compensation policy as a governance mechanism for Compensation policy as a governance mechanism for incentive alignment between management and incentive alignment between management and shareholdersshareholdersProperly designed executive pay can help Properly designed executive pay can help attractattract, , retainretain, and , and motivatemotivate executive talent executive talent andand align with align with shareholder interests for shareholder interests for long termlong term performance.performance.Executive stock ownership Executive stock ownership [accumulated through [accumulated through personal investment, retention of shares from option personal investment, retention of shares from option exercise, outright stock grants]exercise, outright stock grants] is presumed to make is presumed to make executives to think like executives to think like ““ownersowners””..Thus, getting incentives right helps allocate resources Thus, getting incentives right helps allocate resources optimally, leading to maximum value creation and optimally, leading to maximum value creation and contribution to economic growthcontribution to economic growth

Executive CompensationExecutive CompensationDark SideDark Side

Misaligned incentives in executive pay can destroy value Misaligned incentives in executive pay can destroy value When a component of pay is tagged to shortWhen a component of pay is tagged to short--term profits, as often bonus term profits, as often bonus pay is, it incentives executives to be shortpay is, it incentives executives to be short--term oriented.term oriented.•• For instance, R&D detracts from current profits, but has longFor instance, R&D detracts from current profits, but has long--run run

consequences for value creation consequences for value creation Option contracts with short vesting elements create incentives fOption contracts with short vesting elements create incentives for or managing analysts expectations for a shortmanaging analysts expectations for a short--term runterm run--up in stock priceup in stock priceEven when shortEven when short--term focus is eliminated, overly generous option contracts term focus is eliminated, overly generous option contracts can actually make executives more aggressive in terms of undertacan actually make executives more aggressive in terms of undertaking king excessively high risk activities.excessively high risk activities.Thus, from an overall economic standpoint, illThus, from an overall economic standpoint, ill--designed compensation designed compensation contracts can contribute instability in the system, and to the kcontracts can contribute instability in the system, and to the kind of crisis ind of crisis we have just witnessed. we have just witnessed. •• Index of incentive alignmentIndex of incentive alignment•• PayPay--performance sensitivityperformance sensitivity

PayPay--Performance SensitivityPerformance SensitivityTo What Extent Does Pay Vary with Shareholder Wealth?To What Extent Does Pay Vary with Shareholder Wealth?

Jensen and Murphy (1990) found that topJensen and Murphy (1990) found that top executive executive pay increased only $3.25 for every $1000 increase in pay increased only $3.25 for every $1000 increase in shareholder wealth.shareholder wealth.•• The regression estimate from relating a change in total The regression estimate from relating a change in total

CEO pay to change in firm performance.CEO pay to change in firm performance.JM concluded that executive pay is rather insensitive JM concluded that executive pay is rather insensitive to shareholder wealth. No academic consensus, to shareholder wealth. No academic consensus, though, on the right level of sensitivity.though, on the right level of sensitivity.However, a number of recent studies have found that However, a number of recent studies have found that pay is more aligned than suggested by the original JM pay is more aligned than suggested by the original JM estimates. estimates.

PayPay--Performance Sensitivity: TrendsPerformance Sensitivity: TrendsMean Sensitivity of CEO Wealth to Performance Mean Sensitivity of CEO Wealth to Performance

for S&P 500 Firms ($1000sfor S&P 500 Firms ($1000s))

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PayPay--Performance Sensitivity: Recent Performance Sensitivity: Recent TrendsTrends

Steady increase in the sensitivity of total CEO pay to firm Steady increase in the sensitivity of total CEO pay to firm performance since the JM study performance since the JM study (see Figure).(see Figure).The dramatic increase in the use of stock options since 1980s The dramatic increase in the use of stock options since 1980s has fueled the payhas fueled the pay--performance sensitivity (Murhphy, 1999; performance sensitivity (Murhphy, 1999; Core, Guay, and Larcker, 2002; Hall and Murphy, 2003).Core, Guay, and Larcker, 2002; Hall and Murphy, 2003).•• The average grantThe average grant--date value of options soared from near date value of options soared from near

zero in 1970 to over $7 million in 2000.zero in 1970 to over $7 million in 2000.•• The value fell to $4.4 million in 2002, but has since risen The value fell to $4.4 million in 2002, but has since risen

back to about $ 6 in 2005.back to about $ 6 in 2005.•• The upward trend in option grants was not accompanied by The upward trend in option grants was not accompanied by

a commensurate increase in base salary, leading to a a commensurate increase in base salary, leading to a dramatic change in pay structure. Base salary as a percent dramatic change in pay structure. Base salary as a percent of average total pay: 38% in 1992 vs 17% in 2000.of average total pay: 38% in 1992 vs 17% in 2000.

•• PPS continued to rise until 208 when it fell together with PPS continued to rise until 208 when it fell together with the level of pay amid the crisis.the level of pay amid the crisis.

Rising PPSRising PPSGood News/Bad NewsGood News/Bad News

The upward trend in the payThe upward trend in the pay--performance sensitivity performance sensitivity is also evident in the banking industry.is also evident in the banking industry.•• Fahlenbrach and Stulz (2009) found, for a sample of bank Fahlenbrach and Stulz (2009) found, for a sample of bank

CEOs, an increase in CEO wealth of about $24, on average, CEOs, an increase in CEO wealth of about $24, on average, for every $1000 of shareholder value created for every $1000 of shareholder value created [8 times the [8 times the JM original estimate].JM original estimate].

•• Base salaries constituted only 10% of total compensationBase salaries constituted only 10% of total compensation. .

Overall, consistent with the agency paradigm, the Overall, consistent with the agency paradigm, the growing evidence suggests that a substantial portion growing evidence suggests that a substantial portion of CEO wealth is being tied to company performanceof CEO wealth is being tied to company performanceHave increases in option grants induced excessive Have increases in option grants induced excessive paypay--performance sensitivity (overperformance sensitivity (over--incentivized)? incentivized)? [The dark side of PPS!][The dark side of PPS!]

Compensation Setting Process Compensation Setting Process and and Debate on Excessive PayDebate on Excessive Pay

The level of CEO pay in large US firms has surged The level of CEO pay in large US firms has surged dramatically over the past three decades dramatically over the past three decades (see Figure)(see Figure)

Primarily driven by an explosion stock option Primarily driven by an explosion stock option grantsgrantsIncreases particularly pronounced in Increases particularly pronounced in manufacturing and financial services, and manufacturing and financial services, and higher in larger firms [Gabaix and Landier, higher in larger firms [Gabaix and Landier, 2008]2008]

Absolute:Absolute: Average CEO pay for S&P 500 companies Average CEO pay for S&P 500 companies increased from $0.85m in 1970 to $14 min 2000; fell increased from $0.85m in 1970 to $14 min 2000; fell briefly to $9.4m in 2002, and then went back $13.5 m briefly to $9.4m in 2002, and then went back $13.5 m (between 2005 and 2007)(between 2005 and 2007)

But declined to $10.5m in 2008 amid the financial But declined to $10.5m in 2008 amid the financial crisis crisis

Dramatic Rise in PayDramatic Rise in PayAverage CEO Compensation of S&P 500 Firms

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Trends in Compensation Structure Trends in Compensation Structure HighlightsHighlights

Total US executive compensation rose dramatically from Total US executive compensation rose dramatically from 1992 to 2000 1992 to 2000 [$2.5 million in 1992 and $7.9 million].[$2.5 million in 1992 and $7.9 million].It then declined from 2001 to 2003, and started to grow It then declined from 2001 to 2003, and started to grow again in 2004 and in 2008 it was back where it was at is again in 2004 and in 2008 it was back where it was at is peak in at the height of dot.com bubble. peak in at the height of dot.com bubble. A major component of the increase during the 1992A major component of the increase during the 1992--2000 2000 period came from the increase in stock options. It jumped period came from the increase in stock options. It jumped from 20 % in 1992 to 36 % in 2000. from 20 % in 1992 to 36 % in 2000. Interestingly, the recent growth in executive compensation Interestingly, the recent growth in executive compensation is not from stock optionsis not from stock optionsThe proportion of executive compensation coming from The proportion of executive compensation coming from stock option dropped to 30 % in 2003 and in 2008 it stood stock option dropped to 30 % in 2003 and in 2008 it stood at 20%.at 20%.

Compensation Setting Process Compensation Setting Process and Debate on Excessive Payand Debate on Excessive Pay

Relative:Relative: Relative to nonRelative to non--CEOs, 34% more in CEOs, 34% more in 1975 but twice as high in 20071975 but twice as high in 2007

Relative to workersRelative to workers, average pay of top , average pay of top executives was about 40 times larger than of executives was about 40 times larger than of the average worker in 1970; the ratio peaked the average worker in 1970; the ratio peaked at 400 (about) in 2000, declining to 320 at 400 (about) in 2000, declining to 320 (approx) in 2008. (approx) in 2008.

Is pay excessive?Is pay excessive?Popular viewPopular view: excessive pay caused by flawed : excessive pay caused by flawed governance mechanisms in the pay setting governance mechanisms in the pay setting processprocess

Are Executives Paid Too Much?Are Executives Paid Too Much?

Striking examples of Striking examples of ““excessiveexcessive”” pay packages pay packages abound.abound.Robert NardelliRobert Nardelli, Home Depot: $210 million pay, Home Depot: $210 million pay•• In part, $20 million in severance, $77 million in In part, $20 million in severance, $77 million in

deferred stock awardsdeferred stock awardsRichard GrassoRichard Grasso: 187.5 million pay: 187.5 million pay•• NYSE notNYSE not--forfor--profit at the timeprofit at the time

Dennis KozlowskiDennis Kozlowski, former CEO of Tyco; granted , former CEO of Tyco; granted nearly six million new options ( 5.1 million s in Tyco nearly six million new options ( 5.1 million s in Tyco plus 800,000 options in a subsidiary): valued at $81 plus 800,000 options in a subsidiary): valued at $81 million million •• (at the very time that he was allegedly looting the (at the very time that he was allegedly looting the

company of millions of dollars). company of millions of dollars).

A Stand on Excessive PayA Stand on Excessive Pay

The foregoing exorbitant pay packages, The foregoing exorbitant pay packages, particularly to those executives who are particularly to those executives who are undeserving, show that there may be undeserving, show that there may be incidences of excessive pay.incidences of excessive pay.But we cannot generalize from these cases But we cannot generalize from these cases whether the average level of executive whether the average level of executive compensation is excessive. compensation is excessive. At best agnostic! At best agnostic! The academic sentiment seems consistent with The academic sentiment seems consistent with this view. this view. In fact, argue against legislating level or In fact, argue against legislating level or structure of pay.structure of pay.

Regulating Excessive PayRegulating Excessive PaySection 162 (m) of the Revenue CodeSection 162 (m) of the Revenue Code

The tax law was enacted in 1993The tax law was enacted in 1993Disallowed tax deductibility of all Disallowed tax deductibility of all compensation paid to executives in excess of compensation paid to executives in excess of $1 million$1 millionUnless such compensation takes the form of Unless such compensation takes the form of ““performanceperformance--basedbased”” compensationcompensationHouse Ways and Means Committee: House Ways and Means Committee: ““The The committee believes that excessive compensation will committee believes that excessive compensation will be reduced if the deduction for compensation (other be reduced if the deduction for compensation (other than performancethan performance--based compensation) paid to the based compensation) paid to the top executives of publicly held corporations is limited top executives of publicly held corporations is limited to $1 million per yearto $1 million per year””

Executive Pay CapExecutive Pay CapUnintended ConsequencesUnintended Consequences

Stock options satisfied the Stock options satisfied the ““performanceperformance--basedbased”” test, test, since they are linked to the companysince they are linked to the company’’s stock values stock value•• Hence, viewed less expensive than base salaries Hence, viewed less expensive than base salaries

and stock grantsand stock grants162 (m) caused many firms to reduce salaries below 162 (m) caused many firms to reduce salaries below $1 million, but other pay components, $1 million, but other pay components, especially especially stock optionsstock options, increased dramatically , increased dramatically (Perry and (Perry and Zenner, 2001)Zenner, 2001)Lesson:Lesson: direct regulation of executive pay can cause direct regulation of executive pay can cause unintended consequencesunintended consequences, e.g., substitution of one , e.g., substitution of one form of compensation for anotherform of compensation for anotherOveruse of stock options is partly blamed for Overuse of stock options is partly blamed for overincentivization and the corporate scandals overincentivization and the corporate scandals associated with the dot.com bubble. associated with the dot.com bubble.

Regulation of Executive PayRegulation of Executive PayWhile supporting the need to reform corporate While supporting the need to reform corporate governance mechanisms influencing compensation governance mechanisms influencing compensation setting, we should not support direct or indirect setting, we should not support direct or indirect efforts to legislate or regulate compensation levels efforts to legislate or regulate compensation levels and structures. In particular, section 162 (m) of the and structures. In particular, section 162 (m) of the Internal Revenue Code is a clumsy attempt to Internal Revenue Code is a clumsy attempt to regulate the level and structure of executive pay. regulate the level and structure of executive pay. Section 162 (m) of the IRS code should be Section 162 (m) of the IRS code should be repealed!repealed!More broadly, the choice of compensation structure More broadly, the choice of compensation structure should be left to the firm, and accounting, should be left to the firm, and accounting, regulatory, and tax treatments should not favor one regulatory, and tax treatments should not favor one form of compensation over another (e.g., stock form of compensation over another (e.g., stock options over cash or stock).options over cash or stock).

Pay and GovernancePay and GovernanceCompensation setting process interfaces with Compensation setting process interfaces with quality quality of of corporate governancecorporate governance..The literature suggests that when corporate The literature suggests that when corporate governance mechanisms are weak, executives can governance mechanisms are weak, executives can influence, and even dominate, the influence, and even dominate, the nomination processnomination processfor directors in the compensation committee; also, for directors in the compensation committee; also, they can exert influence through they can exert influence through interlocking boardsinterlocking boards. . According to this view, the escalation in executive According to this view, the escalation in executive pay reflects transfer of wealth from shareholders.pay reflects transfer of wealth from shareholders.This view has received wide attention in the popular This view has received wide attention in the popular press, especially after the outrage over high bonuses press, especially after the outrage over high bonuses at financial institutionsat financial institutions

Pay and GovernancePay and GovernanceMixed EvidenceMixed Evidence

OO’’Reilly, Main, and Crystal (1988) find that CEO pay is Reilly, Main, and Crystal (1988) find that CEO pay is positively related to pay of compensation committee members positively related to pay of compensation committee members who are themselves executives in other firmswho are themselves executives in other firmsCore, Holthausen, and Larcker (1999) find that the empirical Core, Holthausen, and Larcker (1999) find that the empirical relation between measures of internal governance and the relation between measures of internal governance and the level/structure of CEO pay is weak.level/structure of CEO pay is weak.Cases against rent extractionCases against rent extraction: Murphey and Zabojnik (2003) : Murphey and Zabojnik (2003) find that large increases in compensation accrued to find that large increases in compensation accrued to professional CEOs hired from outside the firm rather than professional CEOs hired from outside the firm rather than insiders promoted from inside the firm. insiders promoted from inside the firm. Size and paySize and pay: the variation over time in average CEO pay : the variation over time in average CEO pay appears to largely mimic the path of average firm value over appears to largely mimic the path of average firm value over the last 3 decades the last 3 decades (Figure).(Figure).

Average CEO CompensationAverage CEO Compensationvsvs Market Capitalization of S&P 500 Firms ($M)Market Capitalization of S&P 500 Firms ($M)

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Pay and GovernancePay and GovernanceReformsReforms

Objective:Objective: maximize the likelihood that executive pay setting process is maximize the likelihood that executive pay setting process is conducted on an armsconducted on an arms--length basislength basis

Committee independenceCommittee independence: : The compensation committee should be mostly The compensation committee should be mostly composed of independent directors. The committee should retain composed of independent directors. The committee should retain independent compensation consultants, and they should be recruitindependent compensation consultants, and they should be recruited by the ed by the board and not by the CEO.board and not by the CEO.

Financial literacyFinancial literacy:: Need for sufficient financial literacy on the committee, Need for sufficient financial literacy on the committee, including adequate knowledge of finance, particularly the valuatincluding adequate knowledge of finance, particularly the valuation and the ion and the role of instruments used in executive compensation (stocks and orole of instruments used in executive compensation (stocks and options).ptions).

Compensation disclosureCompensation disclosure:: Call for disclosure rules for executive Call for disclosure rules for executive compensation to be more explicit about all elements of executivecompensation to be more explicit about all elements of executivecompensation, including retirement benefits and indirect compenscompensation, including retirement benefits and indirect compensation, ation, such as perquisites such as perquisites [new SEC rules are getting close].[new SEC rules are getting close].

Pay and GovernancePay and GovernanceSay on PaySay on Pay

Proposal:Proposal: all top executive compensation all top executive compensation plans {salary, equityplans {salary, equity--linked compensation, linked compensation, severance packages, etc.] must be approved by severance packages, etc.] must be approved by shareholders (via a proxy vote)shareholders (via a proxy vote)Proponents:Proponents: argue that because senior argue that because senior executives have inordinate influence over the executives have inordinate influence over the board (and compensation committee), board (and compensation committee), shareholders need a more direct mechanism to shareholders need a more direct mechanism to impact level and structure of pay.impact level and structure of pay.

Say on PaySay on PayThe Other Side of Debate and VerdictThe Other Side of Debate and Verdict

Central questionCentral question: Are shareholders as informed and : Are shareholders as informed and experienced in assessing pay packages as the board?experienced in assessing pay packages as the board?Shareholders may not be as informed about the complexities of Shareholders may not be as informed about the complexities of executive pay or the dynamics of the CEO labor market as are executive pay or the dynamics of the CEO labor market as are members of the compensation committee.members of the compensation committee.•• The growth of shareholder advisory groups The growth of shareholder advisory groups

Available evidenceAvailable evidence: Faulkender and Yang (2009b): At firms : Faulkender and Yang (2009b): At firms where shareholders expressed dissatisfaction with where shareholders expressed dissatisfaction with compensation packages through shareholder resolutions, rather compensation packages through shareholder resolutions, rather than pay decreasing, firms have altered the composition of the than pay decreasing, firms have altered the composition of the peer group (adding higher paid peers, dropping lower paid peer group (adding higher paid peers, dropping lower paid peers).peers).

Perverse Incentives of Executive PayPerverse Incentives of Executive Pay

While equity incentives can create beneficial incentives, they While equity incentives can create beneficial incentives, they can also create perverse incentives.can also create perverse incentives.Opportunistic executives have incentives to engage in Opportunistic executives have incentives to engage in manipulative activities (e.g., accounting restatements, earningsmanipulative activities (e.g., accounting restatements, earningsmanagement, timing of disclosure) to shore up the current management, timing of disclosure) to shore up the current price and cash out via exercise of vested options and price and cash out via exercise of vested options and subsequently sell shares at inflated prices (e.g., Burns and subsequently sell shares at inflated prices (e.g., Burns and Kedia, 2003)Kedia, 2003)Thus, if the compensation system conditions incentives on the Thus, if the compensation system conditions incentives on the current stock price, it may lead to abuses to inflate the currencurrent stock price, it may lead to abuses to inflate the current t stock price and cash out.stock price and cash out.It is widely believed that shortIt is widely believed that short--term gains can be generated term gains can be generated from stock options when the firm simultaneously utilizes from stock options when the firm simultaneously utilizes aggressive accounting (or even fraud) to support the aggressive accounting (or even fraud) to support the overvalued equity (Jensen, 2005). overvalued equity (Jensen, 2005).

Perverse Incentives of Executive PayPerverse Incentives of Executive Pay

Any proposals for changes in the design of compensation Any proposals for changes in the design of compensation contracts should consider how executives alter their behavior contracts should consider how executives alter their behavior as a result of these changes.as a result of these changes.Risk manipulationRisk manipulation: Incentive features in pay executives to : Incentive features in pay executives to higher risk as well as reward them for better performancehigher risk as well as reward them for better performance•• Managers have a variety of ways to hedge against the risks Managers have a variety of ways to hedge against the risks

of exposure in highof exposure in high--powered contractspowered contracts•• Hard to know if these hedging activities are games that Hard to know if these hedging activities are games that

executives play to remove proper incentives for efficient executives play to remove proper incentives for efficient rebalancing of executive portfolios when firmrebalancing of executive portfolios when firm--specific risks specific risks are excessiveare excessive

•• However, executives are likely to engage in inefficient However, executives are likely to engage in inefficient hedging activities when there is poor corporate governance hedging activities when there is poor corporate governance and oversight.and oversight.

Perverse Incentives of Executive PayPerverse Incentives of Executive PayMore ManipulationsMore Manipulations……

Earnings manipulationEarnings manipulation: There is evidence that the pay : There is evidence that the pay structure creates incentives for managing corporate structure creates incentives for managing corporate information (Burns and Kedia, 2003; Gao and Shrieves, 2002)information (Burns and Kedia, 2003; Gao and Shrieves, 2002)Peer group manipulationPeer group manipulation: There is evidence for gaming the : There is evidence for gaming the peer groups used compensation setting. Highly paid peers are peer groups used compensation setting. Highly paid peers are overrepresented in peer groups to influence the median pay, overrepresented in peer groups to influence the median pay, possibly ratcheting up of executive pay observed over the last possibly ratcheting up of executive pay observed over the last three decades (Faulklender and Yang, 2009)three decades (Faulklender and Yang, 2009)Disclosure manipulationDisclosure manipulation: There is evidence suggesting that : There is evidence suggesting that executives manage disclosure around the option and equity executives manage disclosure around the option and equity grant dates (Yermack, 1007; complementary evidence by grant dates (Yermack, 1007; complementary evidence by Aboody and Kasznik, 2000) Aboody and Kasznik, 2000)

Policy ReformsPolicy ReformsDisclosure reformDisclosure reform: Disclosure empowers shareholders to know how we : Disclosure empowers shareholders to know how we executives are compensated and help them to appropriately infer executives are compensated and help them to appropriately infer the the incentives effects of executive pay. incentives effects of executive pay. •• Disclose all elements of executive compensation, including retirDisclose all elements of executive compensation, including retirement benefits, ement benefits,

severance packages, perquisites, and other direct or indirect scseverance packages, perquisites, and other direct or indirect schemes of hemes of compensation [both summary and comprehensive detailed disclosurecompensation [both summary and comprehensive detailed disclosure]]

Reform in OptionsReform in Options: Vesting improves the linkage of pay to long: Vesting improves the linkage of pay to long--term term performance and mitigates incentives to cash out based on short performance and mitigates incentives to cash out based on short term term results and after favorable short term manipulation of stock priresults and after favorable short term manipulation of stock prices. ces. •• Be transparent about the vesting period for the option grant andBe transparent about the vesting period for the option grant and the period for the period for

the stock after the option exercise of the optionthe stock after the option exercise of the option•• Executives should not be rewarded or punished for outcomes beyonExecutives should not be rewarded or punished for outcomes beyond their d their

control. Include some form of indexation or option contracts thcontrol. Include some form of indexation or option contracts that address the at address the issueissue

Reforms in bonus payReforms in bonus pay: Claw: Claw--back provision for performance related back provision for performance related bonuses, should that performance proves to have resulted from lobonuses, should that performance proves to have resulted from longng--term term value destruction or outright manipulation. value destruction or outright manipulation.

Role of Executive Pay in Financial CrisisRole of Executive Pay in Financial Crisis

Executive compensation has been a prominent and Executive compensation has been a prominent and visible target of regulators and policy makers in visible target of regulators and policy makers in response to the crisis.response to the crisis.The responses have not been uniform across countriesThe responses have not been uniform across countries•• The UK Financial Services Authority controls the structure The UK Financial Services Authority controls the structure

of pay, the time period over which incentive pay is of pay, the time period over which incentive pay is conveyed, and added claw back provisionsconveyed, and added claw back provisions

•• In the US, the pay czar has imposed quantitative limits on In the US, the pay czar has imposed quantitative limits on the amount, structure, and timing of compensation the amount, structure, and timing of compensation payments to toppayments to top--paid executives at firms receiving TARP paid executives at firms receiving TARP funds funds

Role of Executive Pay in Financial CrisisRole of Executive Pay in Financial CrisisA Key QuestionA Key Question

Have flawed compensation structures at Have flawed compensation structures at financial institutions contributed to the current financial institutions contributed to the current crisis?crisis?While many policy makers seem to believe While many policy makers seem to believe that this is the case, the issue is far from settled that this is the case, the issue is far from settled empiricallyempiricallyA subject of vigorous debateA subject of vigorous debate

Role of Executive Pay in Financial CrisisRole of Executive Pay in Financial CrisisSome EvidenceSome Evidence

Executives suffered enormous wealth losses during the 2008 Executives suffered enormous wealth losses during the 2008 financial crisisfinancial crisis•• Fahlenbrach and Stulz (2009) find that bank CEOs with more equiFahlenbrach and Stulz (2009) find that bank CEOs with more equity ty

incentives suffered enormous lossesincentives suffered enormous losses•• Murphy (2009) makes a similar point. The average executive bonusMurphy (2009) makes a similar point. The average executive bonuses es

at TARP bank declined by 84% compared to the decline of 20% fromat TARP bank declined by 84% compared to the decline of 20% fromnonnon--TARP banksTARP banks

Ex post/ Ex ante IssueEx post/ Ex ante Issue: Large : Large ex postex post losses do not mean that losses do not mean that the compensation incentives were right the compensation incentives were right ex anteex ante•• Executives could recognize the possibility of large losses but sExecutives could recognize the possibility of large losses but still till

rationally take on excessive riskrationally take on excessive risk ex anteex ante•• Large Large ex postex post losses are only one of a number of possibilities associated losses are only one of a number of possibilities associated

with risk taking with risk taking ex anteex ante..

Role of Executive Pay in Financial CrisisRole of Executive Pay in Financial CrisisSome EvidenceSome Evidence

Divergence in PayDivergence in Pay--Risk Sensitivity (Vega)Risk Sensitivity (Vega)•• Banks versus NonBanks versus Non--banksbanks

The vega of top management compensation diverged between The vega of top management compensation diverged between banks and nonbanks and non--banks after 1999 banks after 1999 (Deyoung,Peng, and Yang, (Deyoung,Peng, and Yang, 2009; see Figure)2009; see Figure)•• Bank CEO wealth became more sensitive to return Bank CEO wealth became more sensitive to return

volatilityvolatility•• Incentive features in bank executive pay preIncentive features in bank executive pay pre--2007 were 2007 were

associated with risky business policies, particularly associated with risky business policies, particularly increased investments in mortgageincreased investments in mortgage--backed securities and backed securities and increased operating income from private mortgage increased operating income from private mortgage securitizationssecuritizations

Vulnerability of high vega banks risk exposures in crisis and Vulnerability of high vega banks risk exposures in crisis and economic downturns. Linkage to financial crisis?economic downturns. Linkage to financial crisis?

Mean Vega: Banks and NonMean Vega: Banks and Non--BanksBanksSource: DeYoung, Yan, and Pen, 2009

Role of Executive Pay in Financial CrisisRole of Executive Pay in Financial CrisisSome EvidenceSome Evidence

Linkage with financial crisis: Linkage with financial crisis: •• Vulnerability of high vega banks risk exposures in crisis and ecVulnerability of high vega banks risk exposures in crisis and economic onomic

downturns. downturns. •• The vega divergence is accompanied by housing bubble, advent of The vega divergence is accompanied by housing bubble, advent of

complex securitization, and excessive leverage complex securitization, and excessive leverage Many factors have been advanced as contributing to financial Many factors have been advanced as contributing to financial crisiscrisisIt is still an empirical question as to the role executive pay It is still an empirical question as to the role executive pay played in the propagation of financial crisisplayed in the propagation of financial crisisCompensation schemes may have accelerated the flaws in Compensation schemes may have accelerated the flaws in other governance and regulatory mechanisms, leading to the other governance and regulatory mechanisms, leading to the financial crisisfinancial crisisInterlinkages and chains of causality remain an open and Interlinkages and chains of causality remain an open and promising research agendapromising research agenda

Black SeptemberBlack SeptemberThe Collapse of Wall StreetThe Collapse of Wall Street

9/29/20089/29/2008

MortgagesMortgages812 00812.0075 0075.00WachoviaWachoviaMortgagesMortgages32.0032.001.001.00IndymacIndymacMortgagesMortgages310.00310.0026.0026.00WAMUWAMUMortgagesMortgages1,000.001,000.0035.00 35.00 Merrill LynchMerrill LynchMortgagesMortgages639.00639.0028.0028.00LehmanLehman

SubSub--prime prime crisis; paniccrisis; panic

400.00400.0018.0018.00Bear StearnsBear StearnsInsurance, CDSInsurance, CDS1,000.001,000.0080.0080.00AIGAIGMortgagesMortgages3,000.003,000.0055.0055.00Fannie Mae Fannie Mae

SourceSourceAssetsAssets($billion)($billion)

Equity Equity ($billion)($billion)

InstitutionInstitution

Excessive Leverage and Excessive Leverage and Too Big To FailToo Big To Fail

High leverage of banks and shadow banksHigh leverage of banks and shadow banksIncentive effects of insuranceIncentive effects of insurance•• Explicit deposit insuranceExplicit deposit insurance

Depositors have no incentive to monitor risk takingDepositors have no incentive to monitor risk taking•• Too big to fail/implicit insurance Too big to fail/implicit insurance

Thus, high leverage and guarantees (explicit/implicit)Thus, high leverage and guarantees (explicit/implicit)•• Incentives for excessive riskIncentives for excessive risk--takingtaking

Given that the shareholders of the highly levered Given that the shareholders of the highly levered institutions benefit from excessive risk taking, a institutions benefit from excessive risk taking, a compensation structure that makes executives risk compensation structure that makes executives risk aggressive can have a perverse effect aggressive can have a perverse effect [Recall Vega [Recall Vega divergence of the predivergence of the pre--crisis era]crisis era]

Characterizing Excessive Risk-taking

When is a Company Too Big To Fail?When is a Company Too Big To Fail?Bankruptcy Bankruptcy vsvs LiquidationLiquidation

If economically viable, but bankrupt?If economically viable, but bankrupt?•• Too big to go bankrupt?Too big to go bankrupt?

If economically unviableIf economically unviable•• Too big to be liquidated?Too big to be liquidated?•• Keeping Keeping ““deaddead”” cows alive through mass transfer cows alive through mass transfer

of wealth from the tax payersof wealth from the tax payers•• Welfare through economic distortion, but why not Welfare through economic distortion, but why not

direct subsidy/transfer and let the direct subsidy/transfer and let the ““deaddead”” cow die. cow die.

Too Big To FailToo Big To FailResolution Mechanism Resolution Mechanism (Ex Post)(Ex Post)

The presumption is that, if it fails, it poses negative The presumption is that, if it fails, it poses negative externalities to society by way of bringing down other entities externalities to society by way of bringing down other entities and counterparties, etc. and counterparties, etc. The resolution mechanism in the bailout schemesThe resolution mechanism in the bailout schemesAssuming Assuming ““too big to go bankrupttoo big to go bankrupt””•• Equity wipeEquity wipe--out, creditor out, creditor ““wholewhole””•• No privatization of bankruptcy and massive transfer of No privatization of bankruptcy and massive transfer of

wealth to creditorswealth to creditorsResolution Authority as part of current regulatory reform Resolution Authority as part of current regulatory reform legislation legislation Ending Ending ““Too Big to FailToo Big to Fail”” and bailouts at the heart of the and bailouts at the heart of the reform proposalreform proposal

Ex AnteEx Ante MechanismsMechanismsPay and Regulatory DesignPay and Regulatory Design

The current crisis brings home that what happens in The current crisis brings home that what happens in the private sector financial industry matters to society the private sector financial industry matters to society at large at large –– even globally.even globally.This externality provides an opportunity to rethink This externality provides an opportunity to rethink executive pay in a broader context of regulatory executive pay in a broader context of regulatory designdesignIs the pay structure that aligns financial industry Is the pay structure that aligns financial industry executives with shareholders optimal from the executives with shareholders optimal from the society/taxpayer standpoint?society/taxpayer standpoint?Is Is ““goodgood”” governance good for society?governance good for society?

Pay and Regulatory DesignPay and Regulatory DesignThe Case of Banking RegulationThe Case of Banking Regulation

Games:Games: Bank owners/shareholders, Bank owners/shareholders, executives, and regulators. executives, and regulators. •• Also, between regulators and taxpayersAlso, between regulators and taxpayers

Banks are managed by professionals who Banks are managed by professionals who happen to have their own incentives that may happen to have their own incentives that may be in conflict with bank owners and the society be in conflict with bank owners and the society at large. at large. Is this suboptimal from the social standpoint?Is this suboptimal from the social standpoint?

Pay and Regulatory DesignPay and Regulatory DesignThe Case of Banking RegulationThe Case of Banking Regulation

Consider a simple bank management Consider a simple bank management compensation structurecompensation structure (see Figure)(see Figure)•• S >> Super conservative (socially S >> Super conservative (socially

suboptimal risk; too low)suboptimal risk; too low)•• αα >> >> aligned with shareholders (socially aligned with shareholders (socially

suboptimal/excessive risk loan portfoliossuboptimal/excessive risk loan portfolios) )

Incentive Features of Bank Management CompensationIncentive Features of Bank Management Compensation

Bank Management Compensation StructureBank Management Compensation Structure:: Manager gets a fixed Manager gets a fixed salary S>0, and a fraction salary S>0, and a fraction αα of the equity of the bank. Also a of the equity of the bank. Also a bonus bonus λλ, which is increasing in the terminal cash flows realized., which is increasing in the terminal cash flows realized.

S

Equity participation(Equity participation(αα))

Banking Regulation Through Pay Banking Regulation Through Pay IncentivesIncentives

(S, (S, λλ, , αα)>> compensation structure exists consistent )>> compensation structure exists consistent with socially desirable riskwith socially desirable riskA more direct and effective way of influencing managerial A more direct and effective way of influencing managerial return and risk shifting incentivesreturn and risk shifting incentivesReadilyReadily observable by regulators. So risk choices by observable by regulators. So risk choices by

managers can be anticipated. This can thus be incorporated managers can be anticipated. This can thus be incorporated into pricing all claims issued by the bank, including FDIC into pricing all claims issued by the bank, including FDIC insurance.insurance.Policy attention to pay incentives in setting insurance price Policy attention to pay incentives in setting insurance price •• A new FDIC proposal for the riskA new FDIC proposal for the risk--based deposit insurance assessment based deposit insurance assessment

system to be changed to account for the risks posed by compensatsystem to be changed to account for the risks posed by compensation ion schemes.schemes.

Incentive regulation attainable for any degree of capitalIncentive regulation attainable for any degree of capital

Executive Compensation and Executive Compensation and Incentivized Banking RegulationIncentivized Banking Regulation

By incorporating the incentive features of By incorporating the incentive features of compensation in the pricing of the correct FDIC compensation in the pricing of the correct FDIC insurance and at the same time leaving the insurance and at the same time leaving the compensation structure itself to the bankcompensation structure itself to the bank’’s owners, s owners, the regulators can induce bankthe regulators can induce bank’’s owners to choose the s owners to choose the compensation structure that will result in the best compensation structure that will result in the best regulatory outcome, leading to greater stability of the regulatory outcome, leading to greater stability of the banking system.banking system.While there is a dark side of illWhile there is a dark side of ill--designed designed compensation, as we saw earlier, there is a good side compensation, as we saw earlier, there is a good side of compensation, since its incentive features can be of compensation, since its incentive features can be used to achieve a more efficient banking regulation used to achieve a more efficient banking regulation that help stabilize the financial system.that help stabilize the financial system.

Final ThoughtsFinal ThoughtsBroader PictureBroader Picture

Incentives are at the center of the current crisis Incentives are at the center of the current crisis In a broader sense, get incentives rightIn a broader sense, get incentives rightCompensation is not the only way, and it should not Compensation is not the only way, and it should not preclude other mechanisms preclude other mechanisms In the debate on the current crisis and excessive risk In the debate on the current crisis and excessive risk taking, the presumption is that profits are privatized taking, the presumption is that profits are privatized but losses socialized.but losses socialized.To curb these perverse incentives the government To curb these perverse incentives the government could consider instruments such as could consider instruments such as warrantswarrants

Final ThoughtsFinal ThoughtsBroader PictureBroader Picture

The role of warrants may be viewed in the same manner as the The role of warrants may be viewed in the same manner as the government taking claims in the private firms in the government taking claims in the private firms in the ex postex postresolution of the current financial crisis.resolution of the current financial crisis.•• The government, in exchange for bailing out failing The government, in exchange for bailing out failing

financial institutions, is known to have taken equityfinancial institutions, is known to have taken equity--like like claims, such as preferred stock and warrants, as a claims, such as preferred stock and warrants, as a mechanism for repaying the tax payer.mechanism for repaying the tax payer.

What is not appreciated is the What is not appreciated is the ex anteex ante incentive effects of incentive effects of warrants in aligning private incentives with the goals of the warrants in aligning private incentives with the goals of the government.government.Warrants can be used even when the financial system is not in Warrants can be used even when the financial system is not in crisis crisis (i.e., when the sun is still);(i.e., when the sun is still); it can be a prevention tool, in it can be a prevention tool, in addition to being used for government compensation in crisis addition to being used for government compensation in crisis resolution.resolution.Transforming the convexity of levered equity claimTransforming the convexity of levered equity claim

Final ThoughtsFinal ThoughtsTaxation Isomorphic to WarrantsTaxation Isomorphic to Warrants

TaxationTaxation of profitable states works in a fashion of profitable states works in a fashion similar to holding equity or warrants in the private similar to holding equity or warrants in the private firms in a setting of firms in a setting of ex postex post resolution of crisis.resolution of crisis.The effects of taxation are similar to warrants in The effects of taxation are similar to warrants in realigning incentives realigning incentives ex anteex ante in the right away to in the right away to achieve the socially desirable level of risk.achieve the socially desirable level of risk.The use of tax and warrant schemes do not mandate The use of tax and warrant schemes do not mandate specific private activities or risk choices and hence specific private activities or risk choices and hence the imposition of invasive regulation is avoided. the imposition of invasive regulation is avoided. Policy attention to taxation as a mechanism to curb Policy attention to taxation as a mechanism to curb excessive riskexcessive risk--takingtaking•• New IMF proposal for New IMF proposal for ““bank taxbank tax””•• ““Casino taxCasino tax””: Wall Street as a : Wall Street as a ““casinocasino”” [no social [no social

value?]value?]

Too Big To FailToo Big To FailWhere are we now?Where are we now?

PrePre--crisiscrisis•• Excesses of banks and shadow banks: Excesses of banks and shadow banks: Size, Size,

leverage, concentration, interconnectednessleverage, concentration, interconnectedness•• Too big to fail and Too big to fail and implicit guaranteeimplicit guarantee

PostPost--bailout:bailout: Six large banks in play now:Six large banks in play now:•• Bank of America, Citibank, JP Morgan, Wells Bank of America, Citibank, JP Morgan, Wells

Fargo, Goldman Sachs, Morgan Stanley Fargo, Goldman Sachs, Morgan Stanley They have all become GSEs (like FannieMae)!They have all become GSEs (like FannieMae)!Have we created even more TBTFs?Have we created even more TBTFs?