Executive Pay and the Financial Crisis


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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.

In fact, pay arrangements did provide substantial incentives for excessive risk-taking. Under the standard design of pay arrangements, executives were fully exposed to the upside of risks taken but enjoyed substantial insulation from part of the downside of such risks. As a result, executives had incentives to increase risk-taking beyond optimal levels.

The first feature of pay arrangements that generated excessive risk-taking incentives was the partial insulation of executives’ payoffs from effects on long-term shareholder value. Both bonus and equity compensation have had excessive focus on short-term results. Jesse Fried and I warned about this problem and its consequences in our 2004 book Pay without Performance: The Unfulfilled Promise of Executive Compensation. Under the standard design of pay arrangements, executives were able to pocket bonuses based on short-term results and were permitted to unload substantial parts of their equity incentives based on short-term stock prices. These arrangements provided executives with incentives to seek short-term increases in profits even when these came at the expense of piling up latent and excessive risks of an implosion later on.

Bebchuk, Cohen, and Spamann (2010) illustrate the problem through a case study of compensation at Bear Stearns and Lehman Brothers. We document that, notwithstanding the 2008 meltdown of the firms, the bottom lines for the period 2000-2008 were positive and substantial for the firms’ top five executives. These top executives regularly unloaded shares and options, and thus were able to cash out a lot of their equity before the stock price of their firm plummeted. The top executives’ payoffs were further increased by large bonus compensation during 2000-2007; while the earnings providing the basis for these bonuses evaporated in 2008, the firms’ pay arrangements did not contain any “claw-back” provisions that would have enabled recouping the bonuses that had already been paid. Altogether, while the long-term shareholders in these firms were largely decimated, the executives’ performance-based compensation kept them in decidedly positive territory. Bhagat and Bolton (2011) find a similar pattern – pre-crisis cashing out of large amounts of compensation by the CEO that exceeded losses suffered by the CEO from stock price declines during the crisis – for other large financial firms that had to be bailed out during the financial crisis.

The second relevant feature of pay arrangements, analyzed in detail in Bebchuk and Spamann (2010), was the insulation of executives’ payoffs from potential losses to contributors of capital other than the shareholders – such as bondholders, preferred shareholders, and the government as guarantor of deposits. Consequently, in considering choices that could impose large losses on such stakeholders, executives had insufficient incentive to internalize these potential losses. Thus, executives had insufficient incentives to avoid risk-taking that was beneficial for equityholders but whose potential consequences for bondholders and other stakeholders made them excessive on the whole. This second problem reinforced the incentives to take excessive risks produced by the first problem.

Going forward, these two problems can and should be addressed by improved design of pay arrangements. To address the first problem, pay arrangements should generally tie executives’ payoffs to long-term results (along the lines proposed in Bebchuk and Fried (2010) or otherwise). To address the second problem, executives’ payoffs should be tied not only to long-term results for shareholders but also (as Bebchuk and Spamann (2010) advocate) to long-term results for other contributors of capital to their financial firm. Had financial firms used such arrangements in the past, they would have avoided providing excessive risk-taking incentives.

While Fahlenbrach and Stulz (2009) (as well as follow-up work by Erel, Nadauld, and Stulz (2011)) did not find evidence supporting the hypothesis that pay structures have contributed to risk-taking, a substantial number of subsequent studies provide such evidence. Several studies find that risk-taking was associated with the sensitivity of the CEO’s wealth to return volatility (Chesney, Stromberg, and Wagner (2011), DeYoung, Peng, and Yan (2010), Gande and Kalpathy (2011) and Suntheim (2011)). Risk-taking was also identified to have been associated with the sensitivity of the CEO’s compensation to short-term earnings per share (Bhattacharyya and Purnanandam (2011)). Furthermore, consistent with the view that risk-taking incentives were generated by the tying of executive interest to results for equityholders but not for bondholders, risk-taking was found to be negatively correlated with inside debt holdings by bank CEOs (Tung and Wang (2011)) and positively correlated with CEOs’ equity-based compensation (Balachandran, Kogut, and Harnal (2010)). Finally, consistent with the view that executives did at least partly perceive the significant risks they were taking, Cziraki (2011) finds that insiders of banks with the highest exposure to subprime risk increased their equity selling starting in mid-2006.

While the above evidence is telling, it is worth stressing that the body of empirical work beginning to accumulate is unlikely to reveal the full extent of the contribution of incentives to risk-taking. While there is some variation that has enabled researchers to obtain the above results, the variation in the available data is insufficient to identify the full effects of flawed incentives. While some pay arrangements were marginally better than others in relevant respects, financial executives’ pay arrangements generally provided substantially more exposure to short-term results, and substantially less exposure to payoffs of bondholders and other stakeholders, than was necessary to provide optimal risk-taking incentives. Thus, it will be difficult for researchers to identify in pre-crisis data the full difference between actual risk-taking levels and those that would have been chosen under optimal pay arrangements.

The view that compensation incentives likely have an important effect on executives’ decisions has rightly led financial economists to provide strong support to providing executives with incentive compensation. This view also warrants serious concerns about the risk-taking incentives that financial firms provided (and to a substantial extent continue to provide) their executives. Giving these concerns the weight they deserve is important not only for understanding the recent past – which it is – but also for according adequate priority to the task of fixing pay arrangements. Fixing these arrangements to eliminate excessive risk-taking incentives would contribute significantly to maintaining financial stability in the future.


Lucian Bebchuk

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

Join the Conversation

Samuel Munzele Maimbo
January 31, 2012

I agree with the authors view that executive pay had a significant impact on the financial crisis. Human beings respond to incentives and we simoly do not have a formula for 'fixing' compensation in way that eliminates EXCESSIVE risk-taking. I am very much of the view expressed by Bruno Frey and Margit Osterloh in this months Harvard Business Review that we should stop tying pay to performance. It does not work. Worse: it induces executives to take company-killing risks; and forces a short-term perspective of the decisions making process. Although stock bonuses mitigate excession decision making, they do not sufficiently compensate for the lure of cash bonuses tied to short run performance.

January 31, 2012

There is little doubt in my mind that executive pay and incentives contributed to the crisis. At the same time though, I am affraid that the herd mentality of the markets played a huge role as well. Seemingly, when things are good they can only get better (bubbles by definition), and when things are bad they can only get worse (see Europe). The psyche of all the actors involved, be it from house (flipping) buyers all the way to the financial firms that packaged real estate loans and sold them to markets that semed not be getting enough of them all contributed to the downfall. It reminds me of my grand father, if it seems to good or too easy to be true, it probably is. The herd mentality of the market generates these massive booms and busts, everybody is feeding on them, some more, some less ,from households, to real estate agents,to mortgage brokers, to tax services, Bank and finacial firms all the way through to investors everybody wants to be on the gravy train. Even once there are clear signs that speculation is a significant proportion of the trades driving prices up, no one wants to be left behind. Everybody contributed to the financial crash, the problem is that while just about everybody had to take a hair cut as a consequence, most CEOs, and much of the top brass in the financial sector came away pretty much unscathed even when they benefitted from a massive bailouts. Why?

February 08, 2012

Anonymous, you really hit the nail on its head. I think the issue is not whether compensation contributed and everyone was carried along with the market; but Why the financial sector that caused all the problems did not get a fair share of the losses that they inflicted on everyone. It has been reported that the financial sector workers make up the highest earning in the US and UK (and I think about every other place) in recent times. one thing humans may not like is unfairness and very high income inequality and where most of these high earners (e.g. some of the culprits in the crisis) are earning so much and seemingly contributing little to the real economy. Financial services firms seemed to be paying so much to employees and with this crisis, one wonders whether they were really contributing so much to real economic growth and well-being to match their wages (http://www.economist.com/node/21543178). As stated in Economist article "Mr Kaplan and Joshua Rauh of Northwestern University note that investment bankers, corporate lawyers, hedge-fund and private-equity managers have displaced corporate executives at the top of the income ladder. In 2009 the richest 25 hedge-fund investors earned more than $25 billion, roughly six times as much as all the chief executives of companies in the S&P 500 stock index combined...But the relatively large role of the financial sector in English-speaking countries could also be a factor: even more of the top 1% work in finance in Britain than in America".

As Demirguc-kunt and Serven (2010:94) stated "it is the duty of regulators to identify and remedy gaps in information well in advance, and recognize the gradual reduction in transparency that comes with financial engineering and regulatory arbitrage and to nip it in the bud by demanding improvements". This suggests that some financial engineering may not be economically useful and pose great risks to the economic system. So why encourage more of financial engineering for products we do not even understand, maybe under the faith that the markets cannot be wrong in their valuation and the rating agencies cannot be wrong. If the markets are right and the financial models are built on sound economic theories, why worry? But the key issue remains: WHY WERE THE FINANCIAL SECTOR ACTORS, FROM CEOS TO OTHERS, NOT MADE TO PAY A FAIR SHARE OF THE FALL-OUT FROM THEIR ACTIVITIES? I hope going forward, we will not keep assuming that the market is ALWAYS RIGHT and that all kinds of financial instruments from financial engineering always reduce systemic risk and are better for the real economy. Moreover, we may need to encourage talented people to go into more economically productive activities that we understand well enough instead of the esoteric financial engineering activities that they carry out in financial firms. we are watching

Per Kurowski
February 14, 2012

Contributed? Yes! Caused? Absolutely not!

In order to pay those exorbitant bonuses you need exorbitant profits and those were handed to the banks, against basically nothing I would say, by the regulators, by means of amazingly low capital requirements which allowed, just as an example, a bank to lend to Greece leveraging over 60 times.

If your expected risk-weighted return when lending to Greece was one percent, you could then look forward to yearly return on equity over 60 percent on that, and that is truly something to write home about… and to collect big bonuses on.

The saddest part though of this crisis, and perhaps even the most expensive, might be all the opportunities which got lost forever, when banks abandoned traditional bank business, like lending to “risky” small businesses and entrepreneurs, since in that case the banks are only allowed to leverage 12 times… meaning no fun… no bonuses.

Occupy Basel! http://bit.ly/dFRiMs We must stop the regulator nannies from infantilizing our banks!

Chuks Ukachukwu
February 10, 2012

Just to add to the issue of possible solutions going forward, I think it is important that for financial stability, we should not be too afraid of increased regulation of compensation packages for those in the financial services industry, from the CEO to others, and activities in the financial services sector. There should also be increased regulation of financial engineering. Since financial system stability is critical to economic stability and growth, after this crisis, I do not think it is prudent to leave financial service workers to do as they please.

The mainstream economic view was voiced by Demirguc-Kunt and Serven (2010:118) when they stated that " Despite their inherent fragility, financial systems underpin economic development. The challenge of financial sector policies is to align private incentives with public interest without taxing or subsidizing private risk-taking [actually not taxing or subsidizing private risk-taking seems utopian to me as I wonder how this can ever be done in the real world]. Public ownership or too aggressive regulation would simply hamper financial development and growth. But striking this balance is becoming increasingly complex in an ever more integrated and globalized financial system". The authors argue that striking a balance is difficult, but also have obviously argued against state/public ownership and aggressive regulation (not sure what aggressive regulation means since we may not really know the right balance and may have to keep trying different types of regulation-both direct and indirect). But state/public ownership and regulation are not always undesirable and can be beneficial if done well as the Chinese state seems to be doing now. Part of getting the balance is to keep experimenting. A recent Economist report (http://www.economist.com/node/21542924) on China stated that "The party has cells in most big companies—in the private as well as the state-owned sector—complete with their own offices and files on employees. It controls the appointment of captains of industry and, in the SOEs, even corporate dogsbodies. It holds meetings that shadow formal board meetings and often trump their decisions, particularly on staff appointments. It often gets involved in business planning and works with management to control workers’ pay. The party state exercises power through two institutions: the State-Owned Assets Supervision and Administration Commission (SASAC) and the Communist Party’s Organisation Department. SASAC, which holds shares in the biggest companies, is the world’s largest controlling shareholder and the state-capitalist institution par excellence. It has been spearheading the policy of creating national champions by consolidating and pruning its portfolio: the number of companies under its supervision has declined from 198 in 2003 to 121 today. It has also been implementing the party’s policy of creating a “harmonious society” by regulating pay. In 2009 the average SOE boss earned $88,000 and the highest-paid, the chairman of China Mobile, $182,000. High pay in SOEs has been a big source of disharmony". In essence, the public interest may demand trading off more financial engineering and high economic growth for the financial engineering and economic growth that the public thinks creates a harmonious society and in which other human goods are protected. As long as financial innovation and high economic growth are not the only arguments in the objective function of the public, then a balance is required. We may need to learn from the Chinese State capitalism model on how to find the true balance as requested by Demirguc-Kunt and Serven (2010), while overcoming some of the defects, especially as regards fighting corruption and nepotism. we are watching as things unfold