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

Deferred Cash Compensation: Enhancing Stability in the Financial Services Industry

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

Deferred Cash Compensation: Enhancing Stability in the Financial Services Industry

Article excerpt

1. INTRODUCTION

Employee compensation packages at large financial firms have recently been the focus of great concern, in particular because of their possible role in the 2007-09 financial crisis. (1) Especially worrisome is that, while these pay structures are crafted to create shareholder value by rewarding employees for taking risks that increase the value of the firm, they often (perhaps unintentionally) lack robust risk management features. Consequently, the prevailing pay structure before the financial crisis may have created risks to financial stability and, in the downturn, imposed costs on other stakeholders, including taxpayers and creditors. (2) As a result, at no time in recent memory has the balance of risk and return in employee decision making been under greater scrutiny.

A prosperous and healthy banking sector is essential to the growth of the U.S. economy. The health of the banking sector, in turn, rests on a competitive and fluid labor market, especially in the major financial centers. To ensure a competitive market, banks reward employees for their contribution to value creation. In banking, value creation entails risk taking. The costs of poor business decisions in banking are not fully internalized by the employee taking the risk, by the employees trading desk, or by the firm and its owners and creditors; poor business decisions also inflict costs on other stakeholders. This outcome holds whether decision makers act morally and judiciously or, alternatively, engage in fraud and abuse. The effect, however, is likely to be larger in the latter case, owing in part to the obfuscation of critical information that often accompanies fraudulent activities. (3) Therefore, early detection of the problem may be more difficult in these instances, and the longer the delay in detection, the larger the associated destruction of value and the higher the social costs. (4) The key issue, then, is how to design incentive schemes to motivate bank employees to increase the value of the firm and, at the same time, ensure that the employee and the firm also serve the broader public interest. A successful approach to designing these incentive schemes could take many forms. In this article, we focus on one such form: incentives based on employee compensation.

In our framework, employee compensation is designed, first, to encourage a conservative approach to risk (which we refer to here as "conservatism") that better aligns the interests of bank employees with those of creditors and the public while still preserving incentives for creating value. Specifically, we explore incentive features associated with performance bonds--funded through the withholding of some portion of bank employees' compensation--and their prudential application in promoting financial stability. We argue that such a deferred cash program is likely to induce conservatism because it better internalizes the costs associated with risk taking. In this way, deferred cash complements both the bank's internal risk management and public enforcement.

Further, we argue that deferred cash is likely to reduce the free-rider problem because, unlike stock or stock options, deferred cash has no upside potential to gain in value. This effect will, in turn, improve internal monitoring in cases of fraud, abuse, or excessive risk taking because such actions by one or more employees will now potentially have an adverse effect on the welfare of other employees. If a culture of internal information production and sharing exists within the firm, then internal monitoring is akin to a risk control scheme. Therefore, a second motivation for implementing a judicious deferred pay policy is that it is likely to make the firm less risky by promoting information production and sharing.

Third, we argue that aggregation of deferred pay for material risk takers, over many years, can build a liquidity buffer that could be used to help cover any unexpected capital or liquidity shortfall in the event the firm comes under stress. …

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