Document Type

Article

Abstract

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.

Date of Authorship for this Version

2-17-2014

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