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Has executive compensation contributed to the financial crisis?

Asli Demirgüç-Kunt's picture

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.

But how exactly the structure of executive pay affects risk-taking is still a topic of heated debate. Some have argued that—even before the crisis—executive compensation at banks had several features that should have discouraged short-termism and excessive risk-taking: paying bankers with equity or stock options, for instance, should ensure that if the firm’s market value gets wiped out the same fate awaits the paycheck of its senior management. But matters may be more complex. Incentive schemes may emphasize immediate revenue generation over a prudent long-term assessment of credit risk (as was likely the case in mortgage lending); and bonuses awarded today may entail risks that do not become apparent until much later. Both aspects of bank compensation have become the focus of increased regulation intended to discourage bank executives from excessive risk-taking. But our understanding of how incentives at banks translated into actual risk-taking behavior is still limited and regulators struggle to come up with rules that can rein in reckless risk-taking without extinguishing banks’ ability to reward actual performance.

What do you think? I've asked Rene Stulz of Ohio State University and Lucian Bebchuk of Harvard Law School to kick off the debate. Please join us and let us know which side you are on. They'll be posting opening statements later this week on the question: "Has executive compensation contributed to the financial crisis?" The comments section will be open, and we'll also be featuring a poll that will allow our readers to weigh in on the issue.

 

Pro

Lucian Bebchuk

William J. Friedman and Alicia Townsend Friedman Professor of Law, Economics, and Finance at Harvard Law School

Read more about Professor Bebchuk.

Con

René M. Stulz

Everett D. Reese Chair of Banking and Monetary Economics at Ohio State University
 

Read more about Professor Stulz.

Comments

Submitted by Martin on
I would like to hear to hear people's thoughts on the idea that this would have happened regardless of executive compensation. Once someone had the idea of making it possible to lend to people who would be likely to default,and those people were willing to take out these mortgages and loans everyone else was forced down that path; the firms engaged in these practices,from the making of loans to the trading in derivatives were making good profits,if a firm sat on the sidelines it would show poorer results,investors would either leave or force a change management because it was being outperformed by the competition and appeared incompetent. Perhaps our salvation lay elsewhere and not in change of compensation?

Submitted by Anonymous on
My view in this issue is that the 2008 financial crisis was the result of the regulatory weakness of governments. To avoid such crisis in future there is necessary of establishing a super financial regulator similar to ICAO in the avation sector. The super financial regulator would oversee and control international finance in different ways such as establishing a harmonic control system in the member countries. . The member countries will be responsible to regulate their domestic market in harmonic ways matching to the guidelines of the international regulator. There is also necessary to regulate the so called innovation in soft technology which has syphoned the poor people's money in the hand of the new richs. It started with the New Economy phenomina especially after 2000. For example the mobile technology. It is changing month after month. A poor man who does not have sufficient money even to their food, cloth, education and health needs has compulsive wishes to buy newer sets by any means. Ultimately compromising their basic needs. What is the use of a mobile set with camera to a poor man? This and other soft technologies such as television and internet has diverted the income to a certain group of investors. To regulate this phenomina is very much necessary so that product of innovation should be of upgradable type so that their one time investment will not go in wastage. How can we overcome this technological empire which is unjustifiably exploiting the income of the poors and the middle income families?

Submitted by Lydia Ochieng-Obbo on
Although there is a strong correlation between Executive Pay and the Financial Crisis the short-termism and excessive risk taking is also rooted in high stakeholder expectations which puts unrealistic pressure on management mainly due to run away competition ( you can read it as excessive ostentetiousness, greed ) I would also like to point out that there was excessive laxity on the part of the regulatory framework in all spheres of the financial system. While we in Africa were being told to regulate and regulate our colleagues in the developed world were taking free market economics to another level. De regulation became the order of the day. So with unreasonable expectations from the shareholders pushed by the increased consumerism and living larger that life ( earning a lot for doing very little) that most elites have adopted, a lax regulatory and supervisory framework, who is surprised that the Executives took advantage deliberately or not - took unprecedented risks to satisfy their greed and that of their employers.

Submitted by Anonymous on
Financial crises happen from time-to-time. Greed is almost always a factor. The extent of the present crisis, however, was really a result of government mis-management. When bank failure is staring one in the face, the last thing a government should do is force the bank to close. Successful banking is wholly dependent on public confidence. Bank failure destroys public confidence. Greed certainly set off the crisis, though what the internal controllers, regulators and auditors were doing whilst the crisis was developing is a mystery, but if governments had acted to shore up the banks at the outset, as ultimately they were forced to do anyway, the crisis of confidence would have passed quickly and then the other problems could have been sorted out. But governments refuse to take responsibility and look for other scapegoats. It is wholly correct to reduce compensation in the financial sector partly because it encourages risk-taking but what has happened now is that banks take no risk at all (and still the massive compensation!). Banking is a business. I don't know of any other business that is not expected to take risk. It is abnormal risk that should be guarded against. Currently, the 'products' that banks offer pass all the risk to the customer. That is also a dangerous prospect.

Submitted by mhd issa on
first we have to admit that this crises is the top of the ice-berg , governments refuse to take responsibility and bankers are passing the bucket .we must restructure the monetary regulation according to equitable means.

Submitted by Dr. Sapovadia V... on
My question is: are governments sincere to detect reasons and check the causes? May be few governments fall in the line. Rest are cutting the time of their regime and not bothered what happens to economy of the country. Otherwise, if government wishes, early alarm is always possible to ring. Government is sole organ, but thoughts and actions are department wise and there is no coordination among different department or people. This lead to incompatibility among them and hence failure occurred in 2008.

No entity is perfect in this world. Greed of few. Hegemonies of few. Imperialism of few entities. Marketing economies. Communist economies. Mixed economies. Utopian economists. Corruption. Either Unwillingness or Helplessness of governments to solve problems. Blackmailing from few economies. Loyalty to own economy to save job/authority/power/lives. Equally responsible are few more classical problems, which includes, pleasing our own community/country and avoiding to thinking about its effects (bad or good) on other entities..... Thus, the list is unending, and all 7 billion humans on earth are responsible for this crisis. Thus, mine is the neutral path and I’m neither supporting PRO nor to CON. However, both may express their opinion on this broader vision.

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