Mr. Chairman and distinguished members of the Committee, thank you very much for inviting me to testify today.
Below I discuss how executive pay arrangements have produced incentives for excessive risk–taking and contributed to bringing about the current financial crisis, how compensation arrangements can be reformed to avoid such incentives, and what role the government should play in bringing about such reforms.
Section I describes the distortions that have been produced by the short-term focus of pay arrangements, and discusses the best ways for tying executive pay – particularly equity compensation – to long-term results. Section II describes another separate and important source of incentives that has thus far received little attention but that could well have contributed substantially to excessive risk-taking in financial firms: the tying of executive payoffs to levered bets on the value of the bank’s capital. That section also discusses how this problem can be best addressed.
Finally, section III discusses the role of the government. For financial firms that pose systemic risks, bank regulators seeking to protect the safety and soundness of such firms should monitor and regulate the extent to which pay arrangements provide incentives for risk-taking. For other publicly traded firms, the government’s role should be limited to strengthening the rights of shareholders and the governance processes inside firms, and the government should avoid intervening in the substantive choices made by the firms.
A fuller development of some of the points made in Section I can be found in “Equity Compensation for Long-term Performance,” a forthcoming white paper co-authored with Jesse Fried. Sections II and III draw on “Regulating Bankers’ Pay,” a discussion paper co-authored with Holger Spamann, which develops more fully the points made in these sections and is attached as an Appendix.
For simplicity of exposition, I will use the term “banks” to refer also to any other financial institutions that are deemed to pose systemic risk and are therefore the subject of potential government support and government regulation.
I. PAYING FOR LONG-TERM PERFORMANCE
Much attention is now focused on the fact that pay arrangements have provided executives with incentives to focus on short-term results. This problem was first highlighted in a book that Jesse Fried and I published five years ago, Pay without Performance: The Unfulfilled Promise of Executive Compensation, and in a series of accompanying articles. It has recently become widely recognized.
Standard pay arrangements reward executives for short-term results even when these results are subsequently reversed. The ability to take a large amount of compensation based on short-term results off the table provides executives with powerful incentives to seek short-term gains even when they come at the expense of long-term value, say, by creating latent risks of implosion later on.
Because there is now widespread consensus that executives’ interests should be tied to long-term performance, the remaining question is how best to do so. The devil, as is often the case, is in the details. Because of the scope of this written testimony, I will limit myself in this section to a brief discussion of how best to tie equity-based compensation – a central component of standard pay arrangements – to long-term shareholder value.
Grants of equity incentives – options and restricted shares – usually vest gradually over a period of time. A specific number of options or shares vest each year, and the vesting schedule provides executives with incentives to remain with the company (the longer they stay, the greater their entitlement to vested options or shares). Once options and shares vest, however, executives typically have unrestricted freedom to cash them out, and executives often unload them quickly after vesting. This broad freedom to cash out equity incentives has contributed substantially to creating short-term distortions.
To address these distortions, it is desirable to separate, as Jesse Fried and I proposed in Pay without Performance, the time that options and restricted shares can be cashed out from the time in which they vest. As soon as an executive has completed an additional year at the firm, the options or shares that were promised as compensation for that year’s work should vest, and they should belong to the executive even if the executive immediately leaves the firm. But vested options and shares should be “blocked” for a specified period after vesting – the executive should be allowed to cash them out only down the road, which would tie the executive’s payoffs to long-term shareholder value.
Some shareholder proposals and compensation experts have recently been calling for allowing executives to cash out shares and options only upon retirement from the firm. Such a “hold-till-retirement” requirement, however, would not be the best way to go.
Most importantly, such a requirement would provide executives with a counter-productive incentive to leave the firm in order to cash out their stock of options and shares and diversify their risks. Perversely, the incentive to leave will be strongest for executives who have served successfully for a long time and whose accumulated options and shares are of an especially large value. Rather than supplying retention incentives, equity compensation with hold-till-retirement requirements would have the opposite effect.
Similar problems arise under any arrangement tying the freedom to cash out to an event that is at least partly under an executive’s control. Consider, for example, the Administration’s proposal last February that executives of companies receiving TARP funding be permitted to unload shares only after their firms return the funding to the government. Such an arrangement would incentivize executives to return TARP funding even when they shouldn’t be doing so, and it would have little beneficial effect on executives who are anyway expecting to return the funding before too long.
To avoid the above problems, the period during which the vested options and shares are “blocked” and may not be cashed out should be fixed. For example, when options or shares of an executive vest, one-fifth of them could become unblocked, and the executive would be subsequently free to cash them out, in each of the subsequent five years. Because the executive would not be able to accelerate the time of cashing out, this arrangement wouldn’t provide distorted incentives arising from desire to obtain such acceleration. And as long as the executive is working for the firm and options and shares continue to vest, the executives would always have an incentive to care about the company’s share value several years down the road.
Restricting the freedom to cash out vested options and shares for a substantial period after vesting should be only one component (albeit an important one) of the necessary overhaul of equity compensation arrangements. Other elements are necessary to prevent “gaming” at either the front-end (the time of the award) or the back-end (the time of the cashing out) as well as to prevent executives from undoing the effects of the link to long-term share value by using hedging or derivative transactions. A detailed discussion of these elements can be found in my work with Jesse Fried.
II. THE LEVERAGING OF BANK EXECUTIVES’ PAYOFFS
I have thus far discussed problems arising from the short-term focus of standard pay arrangements. These problems have afflicted companies in general – though their consequences might have been especially severe in the case of financial firms – and reforms of the kind discussed in the preceding section should be adopted by both financial and non-financial firms. I now turn to a separate and important source of incentives for excessive risk-taking that is especially relevant for the case of banks.
An analysis of banks’ financing structure and compensation arrangements shows that bank managers’ incentives have been tied to a highly leveraged bet on banks’ assets. Because top bank executives were paid with shares of a bank holding company or options on such shares, and both banks and bank holding companies obtained capital from debt-holders, executives faced asymmetric payoffs, expecting to benefit more from large gains than to lose from large losses of a similar magnitude. As institutions that receive much of their funding from deposits, banks are inherently leveraged. But the standard structure of large banks – whose equity is generally owned by bank holding companies and which pay their executives partly with stock options on the bank holding company’s common shares – have added two or three additional layers of leverage.
The basic point can be seen using a simple example. A bank has $100 of assets financed by $90 of deposits and $10 of capital, of which $4 come from the bank’s bondholders and $6 are equity; the bank’s equity is in turn held by a bank holding company, which is financed by $2 from the bank holding company’s bondholders and $4 of equity and has no other assets; and the bank manager is compensated with some shares in the bank holding company. On the downside, limited liability protects the manager from the consequences of any losses beyond $4. By contrast, the benefits to the manager from gains on the upside are unlimited. If the manager does not own stock in the holding company but rather options on its stock, the incentives are even more skewed. For example, if the manager is paid only with options with an exercise price equal to the current stock price, and the manager makes a negative-expected-value bet, the manager may have a great deal to gain if the bet turns out well and little to lose if the bet turns out poorly.
The crisis has not eliminated the incentives of bank executives to take actions that are beneficial to common shareholders of the bank holding company (or holders of options on such common shares) but are costly to bondholders, depositors, and the government as guarantor of depositors. Indeed, for some banks, the crisis might have made the divergence of interest even worse by reducing the value of executives’ shares, and options to buy shares, in the banks’ holding companies. Such reductions increase the divergence between the interests of executives and the aggregate interests of the bondholders, depositors, and the government as guarantor of deposits (and preferred shareholder in some banks).
The measures adopted by Congress and proposed by the Treasury to regulate executive pay in banks receiving TARP funds – the use of restricted stock in incentive pay and say-on-pay advisory shareholder votes on compensation – attempt to tighten the alignment of the interests of executives and the common shareholders of bank holding companies. The above analysis of the divergence of interest between shareholders and contributors of capital to the bank that are senior to the shareholders indicates that this strategy would not address the identified problem. This is because the shareholders’ interests could well be served by the taking of risks that are detrimental to the government’s interests as preferred shareholder and guarantor of some or all of the banks’ debt. Accordingly, these interests of the government would not be advanced by strengthening the link between executives’ interests and those of the shareholders of bank holding companies.
How could pay arrangements be re-designed to address the identified distortion? To the extent that executive pay is tied to the value of specified securities, it could be based on a broader basket of securities and not only common shares. Rather than tying an executive’s pay to a specified percentage of the value of the common shares of the bank holding company, it could be tied to a specified percentage of the aggregate value of the common shares, the preferred shares, and the bonds issued by either the bank holding company or the bank. In addition, it could be useful to tie the executive’s payoff also to changes in a measure (possibly based on the price of credit default swaps reflecting the probability of default) that reflects changes in the expected costs to the government from the prospect of having to bail out the bank down the road.
Similarly, to the extent that executives receive bonus compensation based on accounting measures, such bonuses could be based not on metrics that reflect the interests of common shareholders, such as earnings per share, but rather on broader metrics that reflect also the interests of preferred shareholders, bondholders, and the government as guarantor of deposits. Such changes in compensation structures would induce executives to take into account the effects of their decisions on preferred shareholders, bondholders, and depositors and thereby would curtail incentives to take excessive risks.
III. THE ROLE OF GOVERNMENT
Having discussed what changes in pay arrangements would curtail incentives to take excessive risks in banks as well as other firms, I turn to the question of what role if any the government should play in bringing about such changes. Some would argue that, even accepting the desirability of significant changes, making such changes should be left to unconstrained choices by private decision-makers and that, at least for firms not receiving public funding, the government should not play any role in the setting of executive compensation.
For public firms that are not banks (or other financial firms posing systemic risk), the government should not seek to limit the substantive arrangements from which private decision-makers may choose. For such firms, the government should solely focus on improving internal governance processes, and then not intervene in the substantive choices made by shareholders and the directors elected by them.
To improve the internal governance processes, it is desirable to strengthen shareholder rights and shareholders’ role in corporate decision-making. I have already testified on this subject two years ago before this committee in a hearing on “Empowering Shareholders on Executive Compensation.” As I stressed then, shareholders’ rights in U.S. public firms are significantly weaker relative to the U.K. and other common law countries. In addition to introducing advisory say-on-pay votes, it is important to strengthen shareholder rights in a number of other ways. In particular, it would be desirable to dismantle existing impediments to shareholders’ ability to replace directors and to shape companies’ corporate governance arrangements.
Financial firms posing systemic risks
I now turn to banks (as well as any other financial firms that under our new financial order will be deemed to pose systemic risk and therefore be the subject both of government protection and regulation). To protect the safety and soundness of banks and limit risks to the government and the economy, regulators have long been monitoring and regulating the capital, lending, and investment decisions of banks.
Because the setting of pay arrangements can also have substantial consequences for the risks posed by a bank to the government and the economy, banks’ regulators should going forward also monitor and regulate the structure of executive compensation in banks. Regulation of executive pay should be an important element of banking regulation in the new financial order, and should remain so long after no banks remain publicly supported.
It might be suggested that it would be sufficient for the government to ensure the adequacy of the internal governance processes that produce executive pay in banks. And government authorities around the world have been paying increasing attention to improving these processes within banks. The Basle committee of bank supervisors has been stressing the importance of the involvement of banks’ boards in pay setting, and both the Obama administration and Congress have sought to facilitate shareholder involvement by introducing say-on-pay advisory votes.
As is the case for non-financial firms, the government should indeed seek to improve the internal governance and pay-setting processes within banks. In the case of banks, however, the government’s role should go beyond ensuring the integrity of internal governance processes. Banks are special. And their special circumstances call for banking regulators’ monitoring and limiting the structure – that is, the substantive terms of pay arrangements – and not only the processes producing them.
When a bank takes risks, shareholders can expect to capture the full upside but part of the downside might be borne by the government as guarantor of depositors. Because bank failure will impose costs on the government and the economy that shareholders do not internalize, shareholders’ interests would be served by more risk-taking than would be in the interest of the government and the economy.
Because shareholders could be served by excessive risk-taking, private decision-making by banks is already substantially constrained by detailed body of regulations that, among other things, restricts private choices with respect to the investments and loans that a bank might make and the reserves it must maintain.
Shareholders’ interest in more risk-taking implies that they could benefit from providing bank executives with incentives to take excessive risks. Executives with such incentives could use their informational advantages and whatever discretion traditional regulations leave them to increase risks. Given the complexities of modern finance and the limited information and resources of regulators, the traditional regulation of banks’ actions and activities is necessarily imperfect. Thus, when executives have incentives to do so, they might be able to take risks beyond what is intended or assumed by the regulators, who might often be one step behind banks’ executives.
Because shareholders may benefit from certain increases in risk-taking, they may have an interest in executives’ having incentives to take excessive risks. As a result, substantive regulation of the terms of pay arrangements – limiting the use of structures that reward excessive risk-taking – can advance the goals of banking regulation. The regulators’ focus should be on the structure of compensation – not the amount – with the aim of discouraging the taking of excessive risks. By doing so, regulators would induce bank executives to work for, not against, the goals of banking regulation.
Opponents of pay regulation in banks will argue that the government does not have a legitimate interest in telling bank shareholders how to spend their money. But it does. Given the government’s interest in the safety and soundness of banks, government intervention here will be as legitimate as the traditional forms of intervention, which limit banks’ investment and lending decisions.
Opponents of regulating executive pay in banks will also argue that regulators will be at an informational disadvantage when setting pay arrangements. But placing limits on compensation structures that incentivize risk-taking would be no more demanding in terms of information than regulators’ direct intervention in investment, lending, and capital decisions. Furthermore, the setting of pay arrangement should not be left to the unconstrained choices of informed players inside banks because such players do not have incentives to take into account the interests of bondholders, depositors and the government in setting pay.
The regulation of bankers’ pay could nicely supplement and reinforce the traditional, direct regulation of banks’ activities. Indeed, if pay arrangements are designed to discourage excessive risk-taking, direct regulation of activities could be less tight than it should otherwise be. Conversely, as long as banks’ executive pay arrangements are unconstrained, regulators should be stricter in their monitoring and direct regulation of banks’ activities.
At a minimum, when assessing the risks posed by any given bank, regulators should take into account the incentives generated by the bank’s pay arrangements. When pay arrangements encourage risk-taking, regulators should monitor the bank more closely and should consider raising its capital requirements.
Monitoring and regulating the substantive terms of compensation of bank executives can and should be a critical instrument in the toolkit of banking regulators. It would help ensure that banks and the economy don’t suffer in the future from the excessive risk-taking that we have witnessed in the years leading to the current financial crisis.