Compensation and Risk Incentives in Banking and Finance

By Cai, Jian; Cherny, Kent et al. | Economic Commentary (Cleveland), September 14, 2010 | Go to article overview

Compensation and Risk Incentives in Banking and Finance


Cai, Jian, Cherny, Kent, Milbourn, Todd, Economic Commentary (Cleveland)


We review why executive compensation contracts are often structured the way they are, analyze risk incentives stemming from various pay schemes, and examine the tendency of the banking and finance industry toward excessive risk-taking. Studying the typical executive pay structures in banking and finance before the financial crisis reveals some potentially problematic practices. These practices may have encouraged "short-termism" and excessive risk-taking, which are two behaviors bank regulators aim to prevent with their recently issued guidance on incentive compensation.

The compensation packages of executives and employees at financial institutions have drawn considerable attention-and in some cases, indignation- in the wake of the recent crisis and the extraordinary government interventions that followed. Prior to the crisis, the financial sector had accounted for 20 percent to 35 percent of domestic profits in the United States for nearly two decades, so perhaps unsurprisingly, workers in this industry were rewarded for such profitability with higher compensation. But following the near collapse of the financial system, bank regulators and the general public are anxious to know whether compensation practices were partially or even largely to blame for the aggressive risk-taking that many institutions engaged in leading up to the crisis.

There has been a debate on this question among regulators, practitioners, and academicians. Some studies find no evidence that compensation affected financial firms' performance during the crisis. Others find various links between managerial compensation and financial firms' risk-taking behavior. Recently, the four major federal bank regulatory agencies- the Federal Reserve, the Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS), and the Federal Deposit Insurance Corporation (FDIC)- jointly issued final guidance on incentive compensation. The goal of the guidance is to prevent two kinds of behavior by banks: pursuing shortterm profits at the expense of the long-term financial health of the organization, and taking imprudent or excessive risks that could jeopardize the safety and soundness of the organization.

To help understand the principles laid out in the guidance and establish the link between compensation and risk-taking, this Economic Commentary explains some common practices for rewarding employees at financial institutions and considers how they encourage or discourage risk-taking. Specifically, we address five questions: What does compensation do? How does compensation affect risk-taking? Are risk incentives stronger in the banking and finance industry? And, finally, are the compensation schemes favored by financial institutions different from those in other industries? If so, have such differences induced higher risk-taking?

Compensation and Incentive Alignment

All the recent attention on pay packages and risk-taking seems to have created the misperception that companies use compensation packages to control the risk incentives their managers. This is in fact not what an optimal compensation contract is primarily intended to do.

The traditional rationale for designing deliberate compensation schemes is that doing so aligns managerial incentives with those of shareholders. A firm's executives are tasked with executing the policies of its board of directors- those who represent the owners of the firm. Although many executives hold large amounts of equity in the firms they manage, they still embody what economists and corporate governance scholars call the "principal-agent problem."

Because an imperfect match exists between the interests of the owners (principals) and managers (agents), managers may at times run the company in a way that advances their own interests over those of shareholders. They may seek to maximize their own power, influence, indispensability, or perquisites instead of overall profitability. …

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