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Yes, there is a good basis for concern that executive pay arrangements have contributed to excessive risk-taking during the run-up to the financial crisis. To be sure, other factors were clearly at work: the environment within which firms operated grew riskier due to asset bubbles generated by macro policies and global factors, and regulatory constraints on risk-taking and capital requirements were too lax. As financial economists generally recognize, however, for any given environment and outside constraints, the performance and risk choices of firms depend substantially on the incentives of firms’ executives. Unfortunately, rather than provide incentives to avoid excessive risk-taking, the design of pay arrangements in financial firms encouraged such risk-taking.
Of course, despite incentives to take excessive risks, some executives might have avoided doing so due to professional integrity, reputational concerns, or fiduciary duty norms. And some executives taking excessive risks might have done so due to their under-estimation of the risks taken. But economics and finance teach us that incentives often matter. Thus, to the extent that pay arrangements provided significant incentives to take excessive risks, the possibility that such incentives in fact contributed materially to the excessive risks taken in the run-up to the crisis should be seriously considered.
Conventional wisdom has it that compensation in the financial industry is responsible for much of the credit crisis. For instance, Paul Krugman states that “reforming bankers’ compensation is the single best thing we can do to prevent another financial crisis a few years down the road.” Unfortunately, the facts are stubborn and they do not fit this conventional wisdom.
Rüdiger Fahlenbrach and I study the incentives of bank CEOs before the start of the crisis and how the performance of banks is related to these incentives in a paper published in the Journal of Financial Economics. Our sample includes 95 large banks for which we have detailed information on CEO compensation, option holdings, and equity holdings. The paper shows that the value of the shares held by CEOs in the companies they managed in 2006 was roughly ten times the value of their total annual compensation. Such large holdings dwarfed annual bonuses (see Table 1). Experts in governance would have argued before the crisis that the interests of these CEOs were well aligned with the interests of the shareholders because they had so much skin in the game. The CEOs of Lehman Brothers and Bear Stearns had equity holdings in their firms worth approximately one billion dollars in 2006. With such holdings, it would have made little sense for CEOs to take actions that knowingly decreased shareholder wealth.
The Question: Has executive compensation contributed to the financial crisis?
In the aftermath of the financial crisis there has been no shortage of finger-pointing in the attempt to identify its underlying causes. The list of potential culprits is long and ranges from bank deregulation to the “alchemy” of credit ratings and structured finance. This debate focuses on one factor that has allegedly contributed to the crisis: greedy bankers and the executive compensation packages that tempted them to, quite literally, bet the bank.
The spectacular collapse of banks whose executives were allegedly paid for performance clearly raises many questions about the link between executive pay and risk-taking. In a recent paper, Thomas Philippon and Ariell Reshef of New York University show that while in 1980 bankers made no more than their counterparts in other parts of the economy, by 2000 wages in the financial sector were 40% higher for employees with the same formal qualifications. The last time such a discrepancy was observed was just prior to the Great Depression—an irony which has not been lost on critics of bank compensation, ranging from regulators to the Occupy Wall Street protesters. But the level of compensation alone may not be the real problem. Many leading economists (see, for instance, op-eds from Alan Blinder and Raghuram Rajan) have emphasized that a much more important (and difficult) question to answer is how the structure of performance pay may encourage excessive risk-taking at all levels of the institution, from traders and underwriters right up to the firm’s CEO.
Editor’s Note: The following is a guest contribution by Susan Lund, Director of Research at the McKinsey Global Institute. She will be speaking at the World Bank on the topic of job creation on January 24 as part of the FPD Chief Economist Talk series.
Perhaps no topic is more pressing today than the growing jobs and employment problem. We estimate that there are 40 million unemployed in high-income countries and tens of millions more who have dropped out of the workforce or are under-employed. Not only does this exact a toll in human misery and dampen lifetime economic prospects, but it also places a drag on aggregate demand and tax receipts at a time when both are sorely needed.
Unfortunately, these 40 million may just be the foretaste of what could be in store. Increasingly, the job market in developed economies is bifurcating: full-time employment, job security and rising incomes for high-skill, technically trained, and entrepreneurial workers—and the opposite for almost everyone else. Factories are becoming places of many robots and a few high-skill technicians. The modern office is becoming more virtual—a network of task specialists who may work remotely and are increasingly likely to be part-time or contract labor. Shops are online; those made of brick and mortar increasingly are self-serve and self-checkout.
How should the relative importance of banks and stock markets change as countries develop? Is there an optimal financial structure—in other words, should the mixture of financial institutions and markets change to reflect the evolving needs of economies as they develop?
Previous research has found that both the operation of banks and the functioning of securities markets influence economic development (Demirguc-Kunt and Maksimovic, 1998; Levine and Zervos, 1998), suggesting that banks provide different services to the economy from those provided by securities markets. Indeed, banks generally have a comparative advantage in financing shorter term, lower risk, well collateralized investments, while arms length markets are relatively better suited in designing custom financing for more novel, longer run and higher risk projects.
However, economic theory also emphasizes the importance of financial structure, i.e., the mixture of financial institutions and markets operating in an economy. For example, Allen and Gale’s (2000) theory of financial structure and their comparative analyses of Germany, Japan, the United Kingdom, and the United States suggest that (1) banks and markets provide different financial services; (2) economies at different stages of economic development require different mixtures of these financial services to operate effectively; and (3) if an economy’s actual mixture of banks and markets differs from the “optimal” structure, the financial system will not provide the appropriate blend of financial services, with adverse effects on economic activity.
Less than six years ago, policymakers were concerned about a credit boom in central and eastern Europe (see, e.g., Enoch and Otker-Robe, 2007). Now, as the Eurozone debt crisis has taken center stage and bank deleveraging has picked up speed, they worry about a massive credit crunch across Europe, with potentially damaging spillover effects around the world.
How did we get here? How big is the problem? And what is the way forward?
The 2008-09 Crisis: From credit crescendo…
A combination of complex global and domestic factors including structural global imbalances, incentives supported by economic policies and implicit government or supra-national guarantees, and industry practices allowed massive amounts of easy credit to flow from domestic and international sources to doubtful parts of the private sector such as risky mortgages and real estate projects, triggering unsustainable credit booms and asset bubbles across the world. (Much has been written on the topic. See, for example, Brunnermeier 2009, or Obstfeld and Rogoff 2009).
See what a profound transformation the internet is producing in information-based sectors. Newspapers are under threat from online news sources and blogs. These same web destinations are becoming less relevant as people simply lift and filter the information they want using RSS feeds. The music CD is being unbundled as customers buy individual tracks online. These songs get remixed and re-distributed across an ever-growing number of online content repositories. Books are increasingly digitized, and customers can now sample content and search for information across entire libraries.
The internet is a destroyer of digital products but a great creator of new kinds of customer experiences. Power has shifted to users: it’s no longer about the packages of content suppliers want to sell but about the content mash-ups users want to consume. Providers’ best response is to try to extract more customer information with each interaction, and use that to deliver even more relevance and convenience to their customers. Think Google and Apple and Amazon: the new corporate battlefield lies in the control of the user interface and the customer intelligence system that supports it.
Yet there is one information-based sector that seems deaf to the great sucking sound of the internet: banking. What is banking but managing information of who has what financial claims on whom? For banking, the internet truly is still just another channel. Sure, it has added transactional convenience, but has it changed how banks talk to us?
I recently conducted a literature review on the impact of tax reforms on private sector development as part of the Investment Climate Impact Project.1 My goal was to take stock of what is currently known about the impact of reforms that the World Bank is supporting in this area and to identify the gaps in knowledge that we ought to fill by conducting more impact evaluations. While tax reforms can have a broad range of effects in the economy, the focus here was on private sector outcomes only, as measured by investment, tax evasion by formal firms, formal firm creation, and firms’ economic performance.
It turns out that most papers in this area study the impact of changing tax rates. Both cross-country and micro-level studies suggest that lowering tax rates can increase investment, reduce tax evasion, promote formal firm creation and ultimately lead to an increase in firms’ sales and GDP growth overall. However, lowering tax rates also has important implications for government revenue and it is thus often difficult to balance the trade-offs between various goals of public policy.
This is not exactly the perfect moment for banks to take on new risks. In such a volatile economic climate as today’s, the seemingly prudent thing would be to do very little. But, in a new World Bank report, Financial Development in Latin America and the Caribbean: The Road Ahead, we argue that the time is right for the financial sector in Latin America and the Caribbean (LAC) to expand sustainably in new directions, to boost economic activity and financial inclusion.
LAC has demonstrated a strong financial footing, having weathered the global crisis of 2008-2009 better than most. After a history of recurring instability, the region’s strengthening of macroeconomic and financial oversight policies helped prevent toxic loans and U.S.-style bubbles. In fact, during the 1980s and 90s, the financial sector was the region’s Achilles heel. Ever since, the financial systems have grown and deepened, becoming more integrated and competitive, with new actors, markets, and instruments flourishing. Now that the successes of LAC’s macro-financial stability are widely recognized and tested, we believe it is the right time to move forward with a broader agenda.
But greater financial stability and resilience has not translated into increased financial services, as compared to the world. Even when savings have accumulated and funds are available for investment.