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.
William J. Friedman and Alicia Townsend Friedman Professor of Law, Economics, and Finance at Harvard Law SchoolRead more about Professor Bebchuk.
René M. Stulz
Everett D. Reese Chair of Banking and Monetary Economics at Ohio State University
- Financial Sector