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Did the structure of banker pay cause the crisis?
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.
Posted by Tyler Cowen on September 21, 2009 at 07:33 AM in Economics | Permalink
Comments
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.
Posted by: JB at Sep 21, 2009 7:55:52 AM
JB, but isn't the point that if structure of pay was a driver of risk, that firms who structured leadership pay differently would have performed differently?
If this misses the point, than what would you propose as an empirical test of the proposition that pay was skewing risk?
If your point that "one could argue he never had this $1 billion" since it was in stock were true, wouldn't that suggest that stock grants reward upside without punishing downside and encourage risky behavior?
It may well be that compensation schemes are structured poorly to the task of incentivizing corporate managers to maximize long-term value creation on behalf of shareholders.
But even that is a very different claim from that misalignment of interests leading to the financial crises whose externalities could conceivably make such pay a matter of public policy.
Posted by: Gary Leff at Sep 21, 2009 8:18:54 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.
Posted by: SteveC at Sep 21, 2009 8:22:05 AM
banker compensation structures encouraged traders to fill the books of their own institutions with absolute shite and lie about it to their managers and risk managers. it was, pure and simple, looting from the inside. the fact that fuld, prince, et al do not admit this has to do with that to do so would be to admit high crimes of malfeasance.
Posted by: redacted at Sep 21, 2009 8:24:21 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.
Posted by: Zamfir at Sep 21, 2009 8:25:38 AM
bank stock is competing against other avenues of investment. resultingly, i-bankers are competing with other i-bankers to push profitability to the limits. if one guy in the whole equation is taking cash w/o stock, the whole equation needs to match his risk/reward balance to remain a valid alternative. the stock guy, although he'd like to play it safe, knows unless he can get similar returns to the cash guy will be replaced. the weakest link and the chain again
Posted by: farmer at Sep 21, 2009 8:34:01 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.)
Posted by: Tom West at Sep 21, 2009 8:57:48 AM
I think the more interesting study would not focus on CEO pay but rather on trader pay-- did they have incentives to focus on short term gains and ignore long term risks? Anecdotally, that's what's been discussed as a cause of the crisis, not executive comp.
The fact that CEOs were ignorant of their trading desks' actual risk exposure is a separate issue.
Posted by: Amitav at Sep 21, 2009 9:05:26 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.
Posted by: Bill at Sep 21, 2009 9:25:23 AM
The point that bank executives lost money in the stock market downturn of 2008-09 is essentially irrelevant.
For this to be relevant the bank executives would have had to assume that the market would crash in 2008-09 and built this into their decision making during the boom.
I'm willing to bet that you can not find a single example of this expectation influencing the decision making of bank executives and/or traders during the boom.
Posted by: spencer at Sep 21, 2009 9:30:13 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.
Posted by: DanC at Sep 21, 2009 9:45:24 AM
Higher salary or larger house distract CEOs
In 2007, Yermack and Liu showed that CEO's with larger houses (say, 10,000 square feet) performed worse,
http://articles.moneycentral.msn.com/Investing/CompanyFocus/CEOMansionsAStockIndicator.aspx
Extending this by ratiocination rather than the valid statistical inferences of Yermack and Liu, we might conclude that any large ownership of assets tends to distract its owner, including distracting the CEO from his/her duties. Moderate CEO compensation below, say, $500,000, defrays other uses of CEO time by purchasing others to do yard work, make house repairs, and make investments. Beyond that moderate compensation, the CEO will spend more time on his/her assets and less time on the company's interests. This asset-distraction likely increases with CEO compensation.
If, indeed, too high a CEO compensation distracts the CEO, then companies should limit their CEO compensation.
Posted by: Jameson Burt at Sep 21, 2009 9:52:49 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.
Posted by: nyongesa at Sep 21, 2009 10:17:02 AM
I'm with Amitav, looking at CEO pay is far too narrow. A study of the bonuses of traders, executives, and other key players is necessary to better understand this issue.
Posted by: LJ at Sep 21, 2009 10:45:36 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.
Posted by: Mark at Sep 21, 2009 11:47:42 AM
Short term thinking in general contributed to the crisis. Excessive focus on the next quarter instead of long term value is an ongoing problem.
It used to be that the fast money big bonus Wall Street culture was tolerable because when the inevitable losses came, they took them like men. This new class is running to the taxpayer for funds and protection while attempting to keep some outlandish compensation structure in the name of "competitiveness." What a scam.
It's the same scam that started the "options align management's insterests with shareholders" nonsense. How about some "deliver long term value or you're fired" common sense from our corporate directors for a change?
Posted by: David at Sep 21, 2009 11:49:51 AM
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...
Posted by: Bill at Sep 21, 2009 12:11:38 PM
FROM Jeffrey Friedman: Tyler could not post my whole article, but it also provides evidence against the idea that traders took risks, given the alternatives. They bought lower-paying AAA tranches of MBS 81 percent of the time, not more lucrative AA tranches that would have provided the same capital relief under the Recourse Rule amendment to Basel I.
But I absolutely agree with everyone who would like to see more studies--indeed, any studies! Can it really be that the G20 is about to adopt elaborate banker-compensation rules without a single study showing that compensation incentives contributed to the crisis??
If anyone knows of any such studies, PLEASE CONTACT ME at edcritrev at gmail dot com.
Posted by: Jeffrey Friedman at Sep 21, 2009 12:12:58 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.
Posted by: Tony at Sep 21, 2009 12:24:34 PM
Or, if you want one more cynical explanation, try this:
Corporation rewards executives with phony or inflated comp (stock) in exchange for corporation receiving phony or inflated assets.
I would be more believing in the articles assertions if they were paying for the stock with cash out of their own pocketbook.
Posted by: Bill at Sep 21, 2009 12:37:56 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.
Posted by: Andrew at Sep 21, 2009 1:08:20 PM
Are there public choice implications in having the government regulate or define "correct" C.E.O pay rates in the finance industry? Or do we simply take it as an article of EXTREME religious faith that GLOBAL regulation of the finance industry will be absolutely smooth and socially optimal in the long run?We could maybe incorporate Western European regulatory standards into the U.S. That should work out well because there is strong evidence that Schumpeterian competition reigns supreme on that continent. LOL
I take global regulation or simply increased domestic regulation of the finance industry as a strong sign that the US wants a managed economy with very few entrepreneurial upsets. And as we all know, an economy without entrepreneurial upsets is usually very stagnant, achieves high rates of structural unemployment, has low income inequality and has almost zero ability to take on new immigrants and offer them a meaningful opportunity to earn a living.
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?
Posted by: John Pertz at Sep 21, 2009 2:27:16 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.
Posted by: dbeach at Sep 21, 2009 2:29:14 PM
Given that all the biggest of the least regulated banks, operated on pay for performance systems that Greenspan believed would insure they wouldn't make systematic mistakes, are now "highly" regulated Fed member banks because they needed access to the lender of last resort, clearly pay for performance provides no protection against systematic mistakes that take the economy off the cliff. The much larger number of regulated banks, financial institutions, and firms suffered far smaller shares of the losses and failures. Yep, this year will see a spike in small bank failures and those bankers didn't get the pay for performance packages, but we don't have the 100% brink of failure for the thousands of small/medium regulated banks that we've seen for the big unregulated pay for performance banks.
Maybe pay for performance might not be the cause of the failures and crisis, but it did nothing to head off the failures and crisis.
If we look at the history of the past century of banking, we had instability before the 30s wave of regulation, a period of stability for nearly a half century, and then increasing instability as the regulation was peeled away with the promise the self interest and pay for performance would work better than regulation - Greenspan's view.
That to me argues for regulation, and brings into question the point and value of pay for performance.
Posted by: mulp at Sep 21, 2009 2:47:59 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?
Posted by: mulp at Sep 21, 2009 2:52:59 PM
