Executive pay and risk taking in banks

Transcription

1 Executive pay and risk taking in banks Marco Pagano University of Naples Federico II, EIEF and Imperial College Lecture at the Internal Market and Services Directorat e General, European Commission 26 January 2012

2 Outline 2 1. Design of bank executive compensation: shareholders and managers incentive problems 2. Effect of executive pay on risk taking and performance of banks during the crisis 3. A neglected channel: competition for bank executives and excess risk taking 4. Rationale for regulation and possible regulatory responses

3 1. Bank executive pay and risk-taking Raising pay-performance sensitivity (bonuses, options) pushes managers to exert more effort, but also to take more risk 3 Good for bank shareholders: most downside risk is borne by other stakeholders (creditors, public insurance agency) True ex post, once debt has been issued and banks are by definition highly levered But ex ante debtholders should anticipate this charge a higher cost of debt to banks whose managers have strong incentives to take risk discipline shareholders Indeed CDS spreads are lower for banks whose managers have greater fraction of deferred compensation and pension payments - at risk in default (Bolton, Mehran & Shapiro, 2011)

4 Why bank shareholders are hard to discipline 4 Can this response by creditors be trusted to deter bank shareholders of banks from giving high-powered incentives to executives? No, for several reasons: commitment problem: shareholders may be unable to precommit to pick moderate incentive schemes, ex post most bank creditors are small, unsophisticated depositors, with no idea of the bank s managers incentives impose no discipline public deposit insurance systems: implicit risk taking subsidy, because it is almost impossible to price the guarantee correctly Moreover, the opportunities for banks to take risk have greatly increased with (i) deregulation and (ii) financial innovation

5 ... and bank managers are hard to discipline too The problem may run even deeper: shareholders may be unable to discipline managers: 5 Bebchuk and Fried (2004): managers control boards design own compensation pay without performance Axelson and Bond (2009): smart workers may be too hard to manage, because their high outside options make them respond less to firing incentives Makarov and Plantin (2010): fund managers may secretly gamble to manipulate performance and attract funds, and thus expose investors to severe losses De Marzo, Livdan and Tchistyi (2010): limited liability may make too costly to keep manager away from gambling

6 2. Executive pay and bank risk in the crisis Crisis strong evidence that pay packages providing greater incentives to risk taking led to higher volatility: 6 Chen, Hong & Scheinkman (2009), Chesney, Stromberg & Wagner (2010), De Young, Peng & Yen (2009), Ellul & Yerramilli (2010), Mehran & Rosenberg (2008), Suntheim (2010) Better alignment with shareholders interests also led to worse performance during the crisis ( bad realization ): Fahlenbrach & Stulz (2009): (i) bank whose CEOs had more stock-based (but not option-based) compensations performed worse; (ii) they lost a lot in the crisis, so had skin in the game Bebchuck, Cohen & Spamann (2009): CEOs pre-crisis bonuses far exceeded these losses

7 3. Neglected channel: competition for managers Common fallacy: considering executive compensation in a bank as if it were in isolation neglecting that pay package is designed to attract managerial talent in competition with others 7 Some have stressed bright side : competition leads to efficient matching: Rosen (1981), Gabaix & Landier (2008), among others But these papers neglect that competition for managerial talent also has a dark side : each employer provides an "escape route" for managers from other companies in doing so, he may affect the manager s risk taking incentives externality!

8 Neglected channel: competition for managers (2) Akin to corporate governance externalities among firms: 8 Acharya and Volpin (2009), Dicks (2009): firms with worse governance must give more incentive pay to their managers competition forces other firms to also pay their managers more, and thus discourages them from improving their governance Cheng (2009): with relative-performance compensation, a firm engaging in earnings management induces others to do the same Acharya, Gabarro and Volpin (2009): evidence that firms use weak governance as tool to attract better managers Upshot: risk-taking in banking may have increased not only because of (i) deregulation and (ii) financial innovation, but also because of (iii) increased competition for managers

9 Practitioners appear aware of this externality 9 It is hard to dispute the idea that excessive focus on short-term incentives and individual performance pumped up the recent credit bubble; similarly, it also seems entirely sensible to call for an incentive structure that rewards greater team-work and longterm vision. The $50m question, though, is: how?... The dirty secret of bank bonuses is that these practices have arisen not merely due to a culture of arrogance; the more pernicious problem is a sense of insecurity. Banks operate in a world where their star talent is apt to jump between different groups, whenever a bigger pay-packet appears, with scant regard for corporate loyalty or employment contracts. The result is that the compensation committees of many banks feel utterly trapped. Gillian Tett (Financial Times, 2009)

10 ... they call it poaching culture 10 In time there was significant erosion of the simple principles of the partnership days. Compensation for top managers followed the trend into excess set by other public companies. Competition for talent made recruitment and retention more difficult and thus tilted negotiating power further in favor of stars.... You had to pay everyone well because you never knew what next year would bring, and because there was always someone trying to poach your best trained people, whom you didn't want to lose even if they were not superstars. Consequently, bonuses in general became more automatic and less tied to superior performance. Roy Smith (Wall Street Journal, 7 February 2009)

11 Model by Acharya, Pagano and Volpin (2011) Model of labor market equilibrium with risk-averse managers, risk-neutral firms 11 scarce managerial talent: alpha = ability to defuse tail risk upon undertaking risk projects symmetric information: neither firm nor manager initially knows alpha learning by employers about managers alpha takes time Such learning is not feasible if employee duration at firms is short compared to maturity of projects they undertake Managers may prefer to switch to new firms to preclude learning: they can take high-risk projects, yet leave before their type is learnt

12 Two scenarios, depending on managers mobility 12 No mobility (= no ex post competition): firms learn about talent and managers are assigned efficiently to tasks: high-alpha to risky projects, low-alpha to safe ones firms insure managers against risk of being low quality result: first best is achieved Mobility (= ex post competition): high-alpha managers fully extract the higher rents by leaving: hence, no co-insurance in anticipation, risk-averse managers may churn across firms preventing their quality to be learnt, getting some insurance but delaying efficient assignment result: delayed learning about managerial alpha and build up of excessive long-term risks

13 4. Rationale for regulatory intervention 13 Regulatory intervention is justified by several reasons (which have emerged so far): 1. most importantly, the costs that excess risk taking by banks imposes on taxpayers to fund bank bailouts and deposit insurance shortfalls 2. the shortcomings of private contracting between shareholders and debtholders (due to limited commitment ability of shareholders) and between shareholders and managers (due to limited liability) 3. the externalities arising from competition in the market for managerial talent The next question is: how can a regulator intervene in this matter?

14 Possible regulatory responses Correct shareholders risk-shifting incentives vis-à-vis creditors and deposit insurance agency: 14 tie CEO pay to the bank s CDS spread (Bolton, Mehran & Shapiro, 2011) or to debt performance (Bebchuk & Spamann, 2010; Edmans & Liu, 2010) limit pay-performance sensitivity of CEO compensation (e.g., fraction of stock- or option-based pay) defer part of the managers compensation ( clawbacks ), so as to (i) make it contingent on no default by the bank and (ii) reduce tail risk raise deposit insurance fees or capital requirements for banks with high pay-performance sensitivity Difficulties: which is preferable? And how should such interventions be designed and implemented?

15 Possible regulatory responses (2) Correct employers poaching incentives: limit bank CEO mobility via tax disincentives 15 cap on managerial pay would also produce the same effect: high-alpha managers would not gain from leaving upon being recognized as such employers could offer insurance to employees churning would become an unattractive way to get insurance limit pay-performance sensitivity of CEO compensation (e.g., fraction of stock- or option-based pay) defer part of the managers compensation ( clawbacks ), so as to allow for learning of managers true alpha Warning: throwing sand in the wheels of the managerial labor market would reduce the market s ability to match banks and managers efficiency loss on this account