Mandatory Long-Term Compensation in the Banking System-And beyond? "Reforms" of Executive Pay May Not Yield Results Much Different from Current Practices

Article excerpt

The past decade has witnessed an impressive turnaround in academic thought on executive pay. Prior to the financial panic of 2008, the leading school of thought--championed perhaps most notably by Harvard professors Lucian Bebchuk and Jesse Fried in their book Pay Without Performance--was that corporate executives had too comfortable a life: they were paid too much, and without regard to the performance of their firms. This led to calls for reform such as the Dodd-Frank "Say on Pay"--giving shareholders the ability to voice an opinion on executive pay packages--and other forms of shareholder empowerment, in the hopes that shareholders would tie executive pay more closely to the performance of the firm.

However, in the economic fallout of the financial panic, the leading school of thought on executive compensation has shifted from prescribing greater performance-based compensation to prescribing compensation systems designed to limit risk-taking and managerial short-termism. In fact, according to these proposals, shareholders cannot be trusted to set executive compensation since shareholders themselves do not bear the full downside when the firm's debt is impaired, employees are laid off, or the government bails out a systemically important firm (as happened with MG, for example). With regard to the substantive components of pay, while not abandoning completely the pre-2008 mantra of pay for performance, these compensation reforms would focus (sometimes exclusively) on long-term results in determining an executive's variable pay. For instance, Bebchuk and Fried now propose that any equity awards managers receive must be restricted so that they cannot be cashed out for a period of years. Going further, Yale professor Roberta Romano would disallow cashing out until some time after the executive's retirement. Such schemes, along with a mechanism for forfeiting pay in the event of malfeasance or poor performance, form the backbone of these new proposals. The sponsors of such plans view them as advisable for most or even all firms--a new set of best practices.

However, in the case of "systemically important" institutions such as large banks and securities firms, these measures are advocated not just as optional best practices but rather as mandatory elements of executives' compensation contracts. The rationale for such a fiat is that the government must backstop institutions that are "too big to fail" or otherwise too systemically sensitive, and as such the government is a major stakeholder- a guarantor and potential residual claimant in the event of failure.

How broadly will these measures apply? If it were merely depositary institutions in the regulatory gunsights, that would be one thing. But given recent moves to regulate hitherto largely unregulated swaths of financial markets--such as hedge funds and private equity- on the grounds that they too are systemically important, forthcoming regulation could be far-reaching indeed.

At the current time, such practices have begun to be implemented and more may be on the way. Dodd-Frank has given regulators authority over executive pay and the Federal Deposit Insurance Corporation recently used that authority to propose two-year clawbacks for executive pay at failed banks. (However, as of the time of this writing, according to The Economist, an insurance market protecting managers against such clawbacks has already developed.) Some investment banks, such as Morgan Stanley, have begun to institute similar measures voluntarily, perhaps in an attempt to forestall further regulation.

This all, then, begs the questions: Are these long-term compensation schemes a good idea? Will they do what their advocates promise? And are there good reasons why firms and shareholders have not adopted such schemes on their own? In this article, I address these questions. In short, while long-term compensation has potential benefits--it can deter bad behavior that will only be observed later and can limit risk taking--such benefit will be limited in scope under all but the most extreme of the plans. …