Did the structure of banker pay cause the crisis?

by on September 21, 2009 at 7:33 am in Economics | Permalink

This is an old topic but it is in the headlines again, so I pass this along, from Jeff Friedman:

This “executive compensation” theory of the crisis
is now the keystone of the conventional wisdom, having been embraced by
President Obama, the leaders of France and Germany, and virtually the
entire financial press. But if anyone has evidence for the
executive-compensation thesis, they have yet to produce it. It’s a
great theory. It “makes sense”–we all know how greedy bankers are! But
is it true?

The evidence that has been produced suggests that it is false.

For
one thing, bankers were often compensated in stock as well as with
bonuses, and the value of this stock was wiped out because of the
investments in question. Richard Fuld of Lehman Brothers lost $1
billion this way; Sanford Weill of Citigroup lost half that amount. A
study by René Stulz and Rüdiger Fahlenbrach[3] showed that banks with
CEOs who held a lot of stock in the bank did worse
than banks with CEOs who held less stock, suggesting that the bankers
were simply ignorant of the risks their institutions were taking.
Journalists’ and insiders’ books about individual banks[4] bear out
this hypothesis: At Bear Stearns and Lehman Brothers, for example, the
decision makers did not recognize the risks until it was too late,
despite their personal investments in the banks’ stock.

The Stulz and Fahlenbrach abstract reads as follows:

We
investigate whether bank performance during the credit crisis of 2008
is related to CEO incentives and share ownership before the crisis and
whether CEOs reduced their equity stakes in their banks in anticipation
of the crisis. There is no evidence that banks with CEOs whose
incentives were better aligned with the interests of their shareholders
performed better during the crisis and some evidence that these banks
actually performed worse both in terms of stock returns and in terms of
accounting return on equity. Further, option compensation did not have
an adverse impact on bank performance during the crisis. Bank CEOs did
not reduce their holdings of shares in anticipation of the crisis or
during the crisis; further, there is no evidence that they hedged their
equity exposure. Consequently, they suffered extremely large wealth
losses as a result of the crisis.

It's entirely fair to argue that these tests are not decisive.  But still, the evidence isn't there — at least not yet — that executive pay was in fact the big problem.

I thank Jeff Friedman for the pointer.

1 JB September 21, 2009 at 7:55 am

Doesn’t that line of argumentation somehow miss the point?
It is not so much about how much Mr. Fuld may have lost (one could argue he never had this $1 billion).
The point is that the way bankers’ pay was structured it encouraged everyone to take enormous risks. They made risky bets. Those bets went wrong. But they still got paid handsomely! The risk-reward profile was completely skewed.

2 SteveC September 21, 2009 at 8:22 am

A little enlightment here. There are two distictly, wildly different types of bankers.

1. Those who work for banks — you know, the places you visit to make a deposit (or at least visit their ATMs).

2. Those who work for securities firms and investment banks. Unless you’re uber wealthy or have one of these guys as a friend or you’re the CEO of a major corporation, you’ve never met one of these folks.

Those in group #1 make reasonable salaries, receive reasonable bonuses and do reasonably well financially. In other words, they are no better off financially than those who work for manufacturing companies or other service companies.

Those in group #2 make reasonable salaries, off-the-chart, gigantic bonuses, often get equity stakes in companies for a few thousand dollars that wind up being worth millions and are able to work hard for 10-15 years (sometimes less) and retire as multi-millionaires.

Please try to make the distinction between the two. I am an executive with a real bank (so you can call be a banker, if you must) and my wife keeps wondering why we haven’t retired yet because she keeps reading about how stinking rich all bankers have become.

3 Zamfir September 21, 2009 at 8:25 am

The rebuttal that they didn’t know what they were doing is not really good evidence that their compensation was well-set either.
Besides, I thought the bonus argument was not aimed in particular at CEOs, but at all levels of the financial world. The idea seems more that the leadership truly believed that the bonus system was in the long term interest of the company, while in practice the rank and file were lead by their (cash!) bonuses towards destructive behavior.

4 Tom West September 21, 2009 at 8:57 am

Except given that mainstream economic thought was that there was no crisis or even strong risk on the horizon (and the few economists that were correct did not have strong enough arguments to convince the mainstream), wouldn’t it have been ludicrous for those bankers to do anything else?

Generally failing to advantage of opportunities that are generally agreed by the experts in the field not to be high risk is cause to be let go. What layman is going to say, “You know, we all know that there’s a 1% chance that every economist of note is wrong and this Roubini guy and a few others are right, so let’s bet that he’s right. Sure we’ll have years of sub-par returns, but I’m certain the stock holders will understand. And if we’re right…”

Really, the risky behaviour would to have been to bet on Roubini et al being right.

Simply put, economics is incapable of providing enough certainty in its predictions to avoid occasional unpredicted crises. The only way to avoid a crisis is to diversify your economy and accept the permanent low returns that accompany that diversification.

And even that is impossible without large scale government direction to force enough people into sub-optimal strategies that we’re sufficiently protected when the unexpected occurs.

(I don’t see gov’t forcing some farmers to abandon mono-crop cultivation, causing food prices to sky-rocket simply because we’re got a small chorus of people predicting catastrophic failure because of the practice.)

5 Bill September 21, 2009 at 9:25 am

The only other alternative hypothesis for the excessive compensation is that they were ignorant of the risks, and were well paid for the ignorance and incompetence. Which would you rather believe: they were greedy or they were ignorant, or they were greedy and not ignorant.

6 DanC September 21, 2009 at 9:45 am

In three years it will be interesting to see if valuations return closer to pre crisis levels. i.e. was the risk being taken that extreme. Or did the combination of an oil price shock, the collapse of the auto industry, and the election of left leaning politicians to the White House, Senate and House, create a perfect storm for a banking crisis.

In any case, having government determine pay rates in banking is wrong. Of course some want to control wages in health care so why don’t we all just relax and let the government control wages and prices.

7 nyongesa September 21, 2009 at 10:17 am

Tyler a rather disappointing title and blog post. For starters, beyond the excellent comments above, there seemed to be numerous primary, secondary and tertiary “causes” and or drivers of the events that transpired last summer, that giving weight to anything called an “executive compensation theory” is just more tree’s for forest navel gazing.

As to COMPENSATION and causality, lets see. I-Bank employees share of the total loot, whilst the highest per head, a la the safe cracker, or “the electronics guy”, versus the get away driver, or muscle, in a heist, were only the top tier of a pyramid of skewed compensation system, that ran all the way down to illegal immigrants at Home depot demanding union scale because they could. By example, My cousins boyfriend worked for Countrywide, and was to the envy of his clique of 20 something state college graduates, the highest paid of the class of 2002. Similarly, our Realtor friend made more money between 2005 and 2007 than the previous decade. And, my wife’s former secretary despite lacking a degree, made 100k+ as an assistant comptroller for an Orange County, California, mortgage broker.

Not to bore you with to many silly personal antidotes, but they/we were all in on the party, and like any really good party the guys manning the bar (Bankers), the guys with keys to the booze celler (The fed), the drunk chicks dancing on the tables (“Flip that House” on BRAVO) and the revelers (Homeowners) were all egging each other on. In all seriousness, your analysis on most subjects is superb, because you recognize the duality of most things, that both sides are generally correct and simultaneously wrong. As bill put it they were both greedy, ignorant, and virtuous. For it was the accepted paradigm that what they were doing was enriching us all.

8 Mark September 21, 2009 at 11:47 am

Agree with Amitav and LJ. Study is way too narrow and omits too many variables for the breadth of its conclusion.

The first commenter wrote:
“The point is that the way bankers’ pay was structured it encouraged everyone to take enormous risks. They made risky bets. Those bets went wrong. But they still got paid handsomely! The risk-reward profile was completely skewed”

I would just point out that, if you eliminate the references to compensation, this describes Fannie Mae, Freddie Mac, and the FHA, among other government institutions, suggesting to me the problem is not entirely one of monetary compensation but broader, that there is a lot of money and credit floating around and everyone seems to use other people’s capital to advance their own interests.

9 Bill September 21, 2009 at 12:11 pm

The argument that they wouldn’t have taken bonuses if they didn’t believe in themselves is a backwards induction argument.

What if they thought their stock would crash by 50%, and then they set their compensation at 2x normal? Look at Fulds comp relative to other years.

Or, and this is a testable hypothesis, what were the stock levels of executives who were known crooks…look at Enron, or MCI. Convicted felons were receiving their comp in stock at high levels too.

Or, what about signalling as part of the deceptive scheme: did you ever think these guys would start selling their stock….it would signal and lead to an immediate collapse.

They were on the merry go round and didn’t know how to get off and were hoping, hoping, hoping…

10 Tony September 21, 2009 at 12:24 pm

It’s true that Fuld lost a lot of money, but I don’t know if it’s relevant. I think if you can make a few hundred million being risky, but there’s a chance you might have to forego a billion, then you’ll probably take it.

I’m as liberal as they come, but regulating compensation makes me uncomfortable. I’d rather regulate some practices and let the compensation sort itself out.

1) Set capitalization standards for every entity over a certain size — no more 30-1 leverage.
2) Put credit-default swaps and things like that on a nice, transparent market.
3) Equalize capital gains taxes with “work” taxes. It’s become more profitable to move money in a circle, rather than making things.
4) Raise taxes on the rich. They got us into this mess, and we’re bailing them out.

11 Andrew September 21, 2009 at 1:08 pm

Who is “They”?

All of them?

Including regulators?

I guess we now need Universal Bankcare because the free market in banking is broken. Nevermind that Universal Bankcare is what got us here.

12 dbeach September 21, 2009 at 2:29 pm

Just wanted to chime in agreeing with commenters who say the issue is not CEO pay, but that of traders and other investment managers whose compensation structure incorporates a kind of optionality.

In general, in the financial industry, if I make a large bet on behalf of a client (who may be, in the case of prop traders, my employer), if I am correct I make a windfall in the form of a huge bonus, but if I am wrong my client loses a lot of money and I get no bonus (and in the worst case, get fired). Note the dramatic asymmetry in the payoffs for the trader. Couple this with the complexity of the instruments being traded, which makes it difficult for the client to gauge how much risk his fiduciaries are taking on, and it is a near-certainty that this structure should lead to excessive risk-taking.

I don’t know how much these compensation structures contributed to the crisis, but I’m sure the answer is not zero.

13 mulp September 21, 2009 at 2:52 pm

Do we any evidence to show that a supremely regulated economy is capable of achieving constant rates of high growth, low unemployment, and a decent output of economic public goods?

The 40s, 50s, and 60s?

Surely you aren’t going to argue that the unregulated economy from say 1860 through 1930 meets your criteria, nor the past decade when we had the least regulation in law and enforcement, are you?

14 Bernard Yomtov September 21, 2009 at 4:20 pm

The idea that the CEO’s were ignorant about the risks to their companies really doesn’t fit well with the argument that they were entitled to their pay.

So maybe it was excessive whichever way you turn.

15 Milton Recht September 21, 2009 at 11:02 pm

I would be surprised if you found any decisive research because the issue is not the risk taking of the employees but the change in their risk behavior due to the compensation structure. You would need a measure of the employees’ risk profile before and after they were exposed to incentive bonus compensation to measure a change due to incentive bonus compensation.

There is the obvious signaling/selection problem. Companies make their compensation structure known during the pre-hiring and hiring process. Anyone applying to the job is attracted to the idea of uncertain compensation based on performance and is already an above average risk taker. The bonus does not entice them to take on excessive risk. It identifies them. The payment structure is a signal to applicants that above average risk takers have a higher probability of hire.

If it is true, that incentive compensation is a signal to identify above average risk takers, then eliminating incentive bonus compensation removes the identification and filtering process. Excessive risk takers will remain in the applicant pool for all related finance and banking jobs. The will apply and find jobs where risk takers are unwanted. We have asymmetric information. Some applicants know they take excessive risk, but employers will not be able to identify them and will hire some of them.

Once employed, they will promote excessive risk taking in average and below average risk taking organizations. These companies might not be prepared for these excessive risk takers. Eliminating incentive compensation may only cause problems for a slew of companies and jobs that are unprepared for and unused to risk taking employees.

16 Money4payday September 22, 2009 at 3:10 am

While it is true that there is no hard evidence to suggest that executive pay packets were one of the principle reasons for the economic downturn, I think it is highly irresponsible of various financial institutions to use the bailout money given by tax payers to provide clearly exorbitant pay packages for its employees.

17 Tony September 22, 2009 at 2:04 pm

There’s no reason to argue the maximalist points here. No one’s talking about a government takeover of the banking system. What’s needed is a few common-sense rules.

18 sal mac September 24, 2009 at 7:28 pm

bank pay scales led to the endimic risk taking
as an engineer most my cohort ended up as traders in london (numerical skill) the expected a fat m8 years and gave or expected no loyality to there company except to acheive the very short term goals set by the senior management even when privatly it was aknowledged to be insane but the money was good
this type of work practise has spread almost the whole way throughout the banking system
take home saleries of which 50% are bonus for achieving sales targets (ie preping you to lie yuor way through the acturial system)
yes pay needs to reflect along term bussness view not a reward for gambling a mill on a sticky valve in bergen on the 15min gas futures

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