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Efforts to control bank risk address the wrong problem in the wrong way. They presume that the financial crisis was caused by CEOs who failed to super­vise risk-taking employees. The responses focus on exe­cutive pay, believing that exe­cu­tives will bring non-execu­tives into line—using incen­­­­tives to manage risk-taking—once their own pay is regu­lated. What they over­look is the effect on non-executive pay of the com­pe­­ti­­tion for talent. Even if exe­­cu­tive pay is regu­lated, and exe­cu­tives act in the bank’s best interests, they will still be trapped into providing incentives that encourage risk-taking by non-executives due to the negative exter­nality that arises from that competition.

Greater risk-taking can increase short-term profits and, in turn, the amount a non-executive receives, potentially at the expense of long-term bank value. Non-executives, therefore, have an incentive to incur signi­fi­cant risk upfront so long as they can depart for a new employer before any losses materialize. The result is an upward spiral in compensation—reducing an execu­tive’s ability to set non-executive pay and the ability of any one bank to adjust com­pen­sation to reflect risk-taking and long-term outcomes.

New regulation must address the tension between compen­sation and compe­ti­tion. Regulators should take account of the effect of competition on market-wide levels of pay, including by non-banks who compete for talent. The ability of non-executives to jump from a bank employer to another financial firm should also be limited. In addition, banks should be required to include a long-term equity compo­nent in non-executive pay, with subsequent employers being restricted from compensating a new employee for any losses she incurs related to her prior work.

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