The question of the debate is whether executive compensation contributed to the crisis. Does contribute mean that executive compensation affected the behavior of executives, or does it mean that executive compensation made the crisis significantly worse? If it means that it affected the behavior of executives, surely that is the case. With different compensation schemes, the financial system would have been different and the crisis would have been different. If it means that it made the crisis worse, how could we know that executive pay made the crisis worse? It is an empirical issue and only empirical work can resolve it. Unfortunately, there is very little empirical work so far because it is so difficult to determine ex ante what excessive risk-taking is and data on executive compensation is limited.
Most of the studies of compensation arrangements in the financial industry look at the named executive officers in banks (i.e., the CEO, CFO, or President) because we have data on the compensation arrangements of these individuals. There has been much conjecture about compensation arrangements of traders in banks, but there is no data and thus no empirical evidence. In addition, even if we had such data, it could not be understood independently of the risk management practices of the institution. To see this, consider a trader: Risk-taking incentives for the trader can be affected by his compensation but also by how his performance is defined. If his funding cost reflects the risks he is taking, his attitude towards risk will be very different from a trader who pays the same cost that his institution pays regardless of the risks he takes.
Turning to the evidence on compensation arrangements for top executives, the published work is the paper that Rudiger Fahlenbrach and I published in the Journal of Financial Economics and the paper that Lucian Bebchuk published with Alma Cohen and Holger Spamann in the Yale Journal on Regulation. Although I discussed my paper already in my first blog post, it is useful to show how different researchers can draw seemingly contradictory conclusions from the same data.
- Financial Sector