Executive Compensation and the Crisis

Rene Stulz has a new working paper which studies the impact of CEO pay on the economic crisis. Studying CEO. The conclusions are interesting:

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.

This is an important study. Perhaps it is not all that surprising, since competition across banks in an asset bubble leads to herding behavior.

This article in the New York Times discusses the controversy. This study is not going to head off reforms on CEO pay. Still, it is important to think about unintended consequences:

“neither bank C.E.O.’s nor regulators thought that banks were taking excessive risks.” So if the risks were viewed as small, he adds, “compensation incentives would not induce them to avoid those risks.”

He points out that in 2006, a collateralized-debt obligation with a triple-A rating didn’t look like a huge risk. “On the contrary, it looked like an extremely low-risk asset,” he says. “Yet, banks incurred extremely large losses on such C.D.O.’s.”

Regulations that would have encouraged executives to take on less risk, he adds, might have made matters worse because executives “might well have chosen to invest even more in AAA-rated C.D.O.’s and other asset-backed securities.”

One could argue, I suppose, that if CEO pay has a common structure, then differences in CEO schemes may not show up in differences in importance, yet the structure is still problematic. That is, all CEO incentive packages could induce risk taking, the differences being less important than the structure itself.

Agency

I've said before that the key problem that led to the crisis was agency. Incentives for financial decision makers encouraged risk taking. An article in today's Wall Street Journal provides some evidence, in the form of earnings of top executives in finance and home-building over the last five years. A key finding:

Fifteen corporate chieftains of large home-building and financial-services firms each reaped more than $100 million in cash compensation and proceeds from stock sales during the past five years, according to a Wall Street Journal analysis. Four of those executives, including the heads of Lehman Brothers Holdings Inc. and Bear Stearns Cos., ran companies that have filed for bankruptcy protection or seen their share prices fall more than 90% from their peak.

Of course such earning filtered all the way through the financial system. Bonuses and earnings were high at investment banks because the risk taking led to high current earnings, and because insufficient attention was paid to the associated risks that the decisions that produced those earnings implied.

The key point is that these people were obviously not stupid, and the crisis is not due to stupidity, but rather to a system that rewards current performance without attention to risk. To paraphrase James Carville, "it was the incentive system stupid."

Financial Crashes and Incentives

Joseph Stiglitz, Nobel Prize winning economist, has an article in the New Republic on excessive risk taking and our financial crisis. He writes:

In recent years, financial markets created a giant rich man's casino, in which well-off players could take trillion dollar bets against each other. I am among those who believe that consenting adults should be allowed great freedom in what they do--as long as they don't harm others. But there's the rub. These high-rollers weren't just gambling their own money. They were gambling other people's money. They were putting at risk the entire financial system--indeed, our entire economic system. And now we are all paying the price.

Stiglitz discusses the incentives to take excessive risks, not surprising for someone who earned his Nobel Prize for information economics.

I think that this is the right focus, but I think the discussion could be sharpened by asking why hedge funds have incentive schemes that reward managers for excessive risk taking. Specifically, why has the system of "2 and 20" (two percent management fee and 20% of profits) survived. This system rewards excessive risk taking since in any good year the manager will earn large profits but the losses go to the shareholders. Other financial institutions face regulations to prevent excessive risk-taking but hedge funds keep their strategies as proprietary secrets -- after all, it is their trading strategies that is the only source of their rents. But why would rich people invest in funds with such incentive schemes? That is the question. We know why managers love it. This is the puzzle we need to solve.