Academic journal article Atlantic Economic Journal

Regulatory Constraints on Performance-Based Managerial Compensation, Bank Monitoring, and Aggregate Loan Quality

Academic journal article Atlantic Economic Journal

Regulatory Constraints on Performance-Based Managerial Compensation, Bank Monitoring, and Aggregate Loan Quality

Article excerpt

Introduction

Regulatory rules designed to limit bank management compensation arrangements emerged in the aftermath of the Panic of 2008 and the associated government-and central bank-financed bailouts of financial institutions. These rules have included establishment of explicit pay ceilings for some institutions receiving exceptional assistance from the U.S. government, the publication and distribution of new supervisory guidelines for bank compensation policies by U.S. bank regulators, incorporation of reviews of pay programs into supervisory examinations, circulation of a proposal by the Federal Deposit Insurance Corporation (FDIC) to condition deposit insurance premiums on management compensation packages [see Adler (2010) and FDIC (2010)], and financial legislation signed into law in 2010 directing the Federal Reserve to establish formal regulatory standards for bank pay practices. As discussed by Hill (2009), similar regulations have advanced in other countries.

A number of critics have expressed concerns that regulating bankers' pay amounts to an effort simply to punish bank managers instead of seeking to implement more meaningful reforms truly aimed at helping prevent future crises. According to these and other critics, the regulation of bank management compensation at best is misguided and at worst counterproductive [see, for example, Mason (2009)]. Nevertheless, some observers suggest that shareholders can benefit from external curbs on management compensation [see, for instance, Grant and Grant (2008)], although most who argue in favor of rules constraining the scope of compensation packages at banks focus on policy-based justifications [see, for example, Macey and O'Hara (2003)]. Among these is the argument that the unregulated utilization of performance-based pay for bank management teams could support efforts by equity holders to shift risk from themselves to other holders of bank debt--including depositors and government deposit insurers [see, for instance, John et al. (2000) and Raviv and Landskroner (2009)]. To the extent that deposit guarantees provide incentives for equity owners to de-emphasize downside risks, this argument suggests that the use of performance-based management compensation contracts might induce managers to pursue these same artificially skewed interests of the equity owners. The concern that performance-based pay might contribute to the shifting of risks to taxpayers motivates most proposals to regulate the terms of bank management compensation arrangements [see VanHoose (2011) for a fuller discussion].

This paper seeks to demonstrate that there is, nevertheless, good reason to be concerned about the possibility for unintended distorting effects of regulatory restraints on performance-based pay. Banks hire managers to perform a variety of functions. One of the more important, highlighted in the work of Diamond (1984, 1991), is to address moral hazard risks via loan monitoring. The objective of this paper is to take seriously the idea that one reason that management teams at some banks receive higher rates of performance-based compensation is that they are better monitors than other management teams that banks might have hired. One key implication that emerges when attention is focused on the managerial loan-monitoring function is that placing binding restraints on rates of performance-based pay for bankers can cause banks to operate less efficiently, while producing the same loan portfolios. Another is that placing sufficiently tight constraints on managerial compensation rates can generate a reduction in the aggregate quality of loans across the banking system.

The banking framework from which these conclusions are derived is intentionally stark. There is a perfectly competitive banking industry comprised of banks that are identically parameterized in all respects except the cost of monitoring loans. Monitoring loans eliminates a known per-dollar deadweight loss on a bank's loan revenues. …

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