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July 22, 2010

Risky Incentives and Executive Pay

Equity-based pay is standard in many industries, but in banking the practice ratchets up risk taking and increases the likelihood of default.


As businesses, banks are unique. Highly leveraged from borrowing large sums against loan and deposit bases, it can be relatively easy for a bank to find itself overextended. Trouble — collapse, bankruptcy or bailout — can easily ensue. This is, in large part, the story of the financial crisis.

Full-tilt leverage by itself is not unique to banks, but unlike other enterprises that rely heavily on debt to produce returns, such as hedge funds and private equity firms, the business of banking touches more directly on the question of moral hazard: when a bank — or any financial services institution — grows large enough, it may become so closely woven into the economy that it becomes too big to fail. Bank executives know that if their risks backfire, a bailout is more likely than not, diminishing their incentives to moderate risk.

Typically, shareholders shy away from moral hazard; if risk rises, so does the chance a firm will lose value or even enter bankruptcy, wiping out shareholders. But a virtually assured bailout means that both stockholders and executives, most often compensated in equity-based pay such as restricted stock and options, are protected against these adverse consequences.

“Governance breaks down in this environment because it’s not clear who is going to care if a financial institution takes on excessive risk,” says Professor Bruce Kogut, whose expertise includes governance, ethics, and financial innovation.

Not all financial institutions fell prey to the temptation of excessive risk. But how did so many institutions run by capable managers and prestigious boards end up taking on such wildly risky bets?

The conventional view of risk and executive compensation is that if the riskiness of a CEO’s choices bears against his own pay and position, the CEO will act in the best interests of a firm’s many stakeholders. “Equity-based pay usually accomplishes this,” Kogut says. “If you make reckless decisions your equity goes down and you personally suffer.”

However, for financial institutions equity behaves like an option once government policy provides implicit insurance against bankruptcy, thereby salvaging the value of equity. The incentive for taking on risk soars: after all, an option can go up in value dramatically; in the worst-case scenario, the option is valued at zero.

Kogut and Professor Sid Balachandran, working with Hitesh Harnal of Columbia University’s Financial Engineering Program, looked at equity prices and data from balance sheets of publicly traded banks and other financial institutions from 1995 to 2008, including credit and mortgage companies and security brokers, dealers, and exchanges.

“Typically, researchers have used the volatility of equity to assess risk, but that doesn’t tell us about excessive risk — it only tells us if equity fluctuates,” Kogut points out. “All firms’ equity is subject to fluctuation particularly during bad periods, but volatility is not the same as default risk.”

Instead of focusing on volatility, the researchers measured risk as the likelihood that an institution would default, and then examined the relationship between likelihood of default and the proportion of the two main types of compensation — cash or equity — that make up the lion’s share of annual executive pay. They used frontier econometric methodologies and financial engineering, using liabilities from balance sheets and equity prices from the stock market to derive what the stock market implicitly thought was the probability that a firm would default.

Across the board, the researchers found that equity-based pay was consistently and significantly associated with an increase in the probability of default. Non-equity-based pay was associated with a decrease in the probability of default.

“In many cases it is good to give people equity-based incentives, though this doesn’t always sit well with the public or policy makers,” Kogut says. “The problem is that if something is good for most industries, we assume it is good for all industries. But in banking it’s not smart to incentivize managers if banks are heavily leveraged and if the government pays for bankruptcy.

“The puzzle is why there was no rational, prudent calculation of risk,” Kogut continues. “It probably points to other things that happen to people in this kind of environment, either competing to be better than the next person or already being so wealthy that gambling with the next $10 million is just a game.”

Is there a better solution than paying CEOs more in bonuses than in options and equity? Professor Patrick Bolton has proposed basing pay on how far a bank’s credit default swap spread is from the industry average (implicitly penalizing increases in default probability); other suggestions include basing pay on how well bank-issued debt performs or instituting clawbacks, in which compensation is deferred pending sustained long-term performance.

None of these proposals made it in to the financial reform bill passed earlier this month, and not everyone agrees that changes are necessary. Many academics and commentators contend that in eras of stronger regulation, financial executives didn’t take on all of the entrepreneurial ventures they should have, causing firms to not perform as well as they could have. They argue that deregulation allowed firms to enter many more ventures and that managers with equity-based pay incentives were the ones grabbing the most entrepreneurial opportunities.

A number of research findings have lent validity to this argument, but Kogut cautions against its wholesale adoption. “We think, and our paper suggests, that it might be true during normal times, but not during catastrophic times,” he says. “And in fact it appears that linking pay to equity encouraged people to take on really excessive levels of risk and do foolish things.

“The standard model for paying executives — or anyone, for that matter — is that to get people to do more, you have to give incentives so that rewards increase when performance improves,” Kogut says. “But that mindset may well be based on a false model of what motivates people. There are plenty of ways to motivate people that don’t require money. It is hard to believe that paying someone a $30 million salary instead of a $25 million salary creates proportionally greater incentives.”

So what do executives care about? Status, Kogut suggests, is probably high on the list: bring back perks such as the corporate jet, country club memberships or charitable giving. “The catch is, these would all go away once an executive leaves the job,” he says. “The larger point is that behavioral motivations might matter more than monetary incentives.”

Sid Balachandran is assistant professor of accounting at Columbia Business School.

Bruce Kogut is the Sanford C. Bernstein & Co. Professor of Leadership and Ethics in the Management Division and the director of the Sanford C. Bernstein & Co. Center for Leadership and Ethics at Columbia Business School.

Read the Research

Bruce Kogut, Hitesh Harnal

"The Probability of Default, Excessive Risk, and Executive Compensation: A Study of Financial Services Firms from 1995 to 2008"

View abstract/citation  View Research  


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