In his opening statement, René Stulz relies on the results of the Fahlenbrach-Stulz study (FS study) to reject the view that executive compensation has contributed to the financial crisis. Stulz argues that the evidence in his study is “inconsistent with the view that banks performed poorly because CEOs had poor incentives.” However, as explained below, the FS study does not provide a good basis for rejecting the poor incentives view.
The FS study attempts to test the “poor incentives” hypothesis by examining whether banks whose CEOs had larger equity holdings performed better during the crisis. Failing to find such an association – and indeed finding that such banks performed worse – the FS study rejects the poor incentives hypothesis. But the poor incentives view does not attribute poor risk-taking incentives to relatively low equity holdings, and the analysis in the FS study does not supply an adequate test of this view.
As I explained in my opening statement, the poor incentives view does not regard large equity holdings as the way to ensure good risk-taking incentives and does not view poor incentives as rooted in insufficient equity holdings. Rather, as I explained, poor incentives have resulted from (i) design of equity compensation (as well as bonus compensation) that rewarded executives even for short-term results that were subsequently reversed, and (ii) linking executive payoffs only to payoffs for shareholders and not also to payoffs for other contributors of capital to financial firms (such as bondholders).
Problem (i) focuses not on the amount of equity compensation but on factors such as the existence and tightness of limitations on unloading equity incentives, as well as on other design elements that make executives more or less focused on short-term prices. Thus, focusing on the correlation between equity holdings and bank performance does not allow us to resolve the extent to which problem (i) played a role during the crisis. Some progress toward such resolution is made by subsequent studies that reach an opposite conclusion to that of the FS study; in particular, Chesney, Stromberg, and Wagner (2011), DeYoung, Peng, and Yan (2010), Gande and Kalpathy (2011) and Suntheim (2011) find that risk taking was associated with the sensitivity of the CEO’s wealth to return volatility, and Bhattacharyya and Purnanandam (2011) find that risk taking was associated with the sensitivity of the CEO’s compensation to short-term earnings per share.
Problem (ii) focuses on the disproportionate ties that executives had to the interests of shareholders over the interests of the non-shareholder stakeholders in banks. Again, the FS study’s finding that banks whose CEOs had larger equity holdings did not perform better during the crisis does not provide any evidence that problem (ii) did not contribute to the financial crisis. On the contrary, the FS study’s finding that banks whose CEOs had larger equity holdings might have performed worse during the crisis, and the finding by Balachandran, Kogut, and Harnal (2010) that risk taking was positively correlated with CEOs’ equity-based compensation, are consistent with the predictions of an analysis focusing on this problem. Further support for the significance of this problem is provided by the findings of Tung and Wang (2011) that risk taking was negatively correlated with inside debt holdings by bank CEOs.
I should stress that the empirical evidence now being accumulated by researchers is unlikely to identify the full extent to which poor incentives contributed to the crisis. To address adequately problem (i), firms should place substantial limitations on the freedom of executives to unload equity incentives (see Bebchuk and Fried (2010) for a detailed blueprint). To address adequately problem (ii), firms should tie the long-term payoffs of executives not only to equity values but also to the value of other slices of the capital structure such as preferred shares and bonds (see Bebchuk and Spamann (2010) for a detailed proposal). Unfortunately, while there has been some variation among the pay structures of financial firms, firms have generally fallen far short of supplying optimal risk-taking incentives, which makes it difficult for researchers to observe the full difference between the actual risk taking in the run up to the crisis and the risk taking that would have taken place under optimal pay structures.
In sum, René Stulz’s statement does not provide us with a basis for dismissing the view that poor incentives contributed to the financial crisis. The logic of incentives, and the body of available empirical evidence, suggest that financial economists should take this view seriously. There is a good basis for concern that executive pay has contributed to the financial crisis.
- Financial Sector