Academic journal article Federal Reserve Bank of New York Economic Policy Review

Incentive Features in CEO Compensation in the Banking Industry. (Part 2: The Governance of Banks)

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Incentive Features in CEO Compensation in the Banking Industry. (Part 2: The Governance of Banks)

Article excerpt


The topic of corporate governance in general, and top-management compensation in particular, has received enormous attention in recent years. (1) Although an increasing literature has examined various aspects of the corporate governance of manufacturing firms in the United States and abroad, the corporate governance of banks and financial institutions has received relatively less focus.

Alignment of the incentives of top management with the interests of shareholders has been characterized as an important mechanism of corporate governance. (2) Managerial ownership of equity and options in the firm, as well as other incentive features in managers' compensation structures (such as performance-related bonuses and performance-contingent promotions and dismissals), serves to align managerial incentives with shareholder interests. In fact, there is a large theoretical and empirical literature on the role of incentive contracts in ameliorating agency problems. (3) The empirical literature has emphasized the role of the relationship between pay and performance, measured as the pay-performance sensitivity of managerial compensation structures. Jensen and Murphy (1990) document that the pay-performance sensitivity of large manufacturing firms is only $3.25 per $1,000 increase in shareholder value. Recent studies show that this sensitivity has increased over time, and most of it comes from option and stock holdings (see Murphy [1999]). (4)

It is important to understand corporate governance and the degree of managerial alignment in banks for several reasons. First, banks differ from manufacturing firms in several key respects. For one, banks are regulated to a higher degree than manufacturing firms. Do the regulatory mechanisms play a corporate governance role? (5) For example, supervision that ensures that banks comply with regulatory requirements may play a general monitoring role. Does this monitoring substitute for or complement other mechanisms of corporate governance? In particular, does regulatory monitoring substitute for the need for incentive features in managerial compensation? (6) By understanding the interaction of regulation and corporate governance, we can gain insight into the optimal design of regulation and corporate governance of banks.

An understanding of the incentive structure that motivates the key decision makers in banks can also be important in designing effective regulation. For example, if top management is very closely aligned with equity interests in banks, which are highly leveraged institutions, it will have strong incentives to undertake high-risk investments (risky loans, risky real estate investments), even when they are not positive net-present-value investments. (7) Regulatory oversight has to take such incentive distortions into account when regulatory procedures are established. John, Saunders, and Senbet (2000) argue that regulation that takes into account the incentives of top management will be more effective than capital regulation in ameliorating risk-shifting incentives. They argue that pay-performance sensitivity of top-management compensation in banks may be a useful input in pricing Federal Deposit Insurance Corporation (FDIC) insurance premiums and designing bank regulation.

Another important aspect that differentiates banks from manufacturing firms is the significantly higher leverage of banks. How does leverage interact with corporate governance and managerial alignment? In addition to conventional agency problems, these highly leveraged financial institutions are susceptible to the well-known risk-shifting agency problems. In these institutions, where depositors are the primary claimholders, the objective of corporate governance is not to align top management closely with the equity holders. Top management should also be given incentives to act on behalf of debtholders to an adequate degree. In such cases, providing managers with compensation structures that have low pay-performance sensitivity may be optimal. …

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