By Simon Johnson
One view of executives at our largest banks in the run-up to the crisis of 2008 is that they were hapless fools. Not aware of how financial innovation had created toxic products and made the system fundamentally unstable, they blithely piled on more debt and inadvertently took on greater risks.
The alternative view is that these people were more knaves than fools. They understood to a large degree what they and their firms were doing, and they kept at it up to the last minute – and in some cases beyond – because of the incentives they faced.
New evidence in favor of the second interpretation has just become available, thanks to the efforts of Sanjai Bhagat and Brian Bolton. These researchers went carefully through the compensation structure of executives at the top 14 US financial institutions during 2000-2008.
The key finding is that CEOs were “30 times more likely to be involved in a sell trade compared to an open market buy trade” of their own bank’s stock and “The dollar value of sales of stock by bank CEOs of their own bank’s stock is about 100 times the dollar value of open market buys” (p.4).
If the CEOs had really believed in what their banks were doing, they would have wanted to hold this stock – or even buy more. Disproportionately more sales than purchases strongly suggests that the CEOs felt their stock was more likely overvalued than undervalued.
The problem runs deeper, as Professors Bhagat and Bolton explain. Given the compensation structure of CEOs – particularly the fact that they can sell stock with very little restriction – they have an incentive to take on excessive levels of risk. When the outcomes are good, as they may be for a while in an up market, the CEO can turn his or her stock into cash. When the outcomes are bad, the CEO doesn’t care so much because he (or she) already has cash – and some form of government bailout or other support may be forthcoming.
Bhagat and Bolton argue that if this incentive problem is important, we should see CEOs make a great deal of money while long-term buy-and-hold shareholders lose money.
Table 4 in their paper shows the amounts of money involved, and they are simply staggering. Collectively the people who headed these 14 institutions pocketed – in hard cash terms – over $2.6 billion during 2000-08. It’s true that the paper value of their wealth dropped in 2008, although this was an unrealized paper loss. But even including that notional loss, the CEOs netted an impressive $650 million.
In contrast, long-term shareholders in these 14 banks did very badly, particularly in 2008 (see Figure 1 in the paper). Bhagat and Bolton show that shareholders in the biggest banks – where CEOs got their hands on more cash – did significantly worse than investors in smaller banks. Interestingly, CEOs in the smallest banks in their sample did not sell much stock relative to their purchases of their own bank’s stock. The big bank-small bank contrast is quite striking.
This points the authors towards moderate but appealing changes in executive compensation practices.
“Executive incentive compensation should only consist of restricted stock and restricted stock options – restricted in the sense that the executive cannot sell the shares or exercise the options for two to four years after their last day in office” (p.37).
The authors are very much on the same page as Professors Admati, Demarzo, Hellwig, and Pfleiderer (and many others in the finance profession), with regard to our need to increase the equity financing of all banks.
“As a bank’s equity value approaches zero (as they did for some banks in 2008), equity based incentive programs lose their effectiveness in motivating managers to enhance shareholder value. Hence, for equity based incentive structures to be effective, banks should be financed with considerable more equity than they are being financed currently.”
This recommendation should be taken on board by all shareholders and their representatives. But who designed and negotiated the compensation packages at issue here, and who is in charge going forward?
The executives in question hire people like Steven Eckhaus, a top Wall Street compensation lawyer, who puts up a spirited defense of current practices and insisted the Wall Street Journal just last weekend that “to blame Wall Street for the financial meltdown is absurd” (p.B13 of Feb.5-6 print edition).
There is no sign that financial sector executives making decisions at our largest banks – and supposedly acting in the interests of shareholders – are at all interested in being compensated in a more responsible fashion that would better protect shareholder value. They want to get the cash out at every opportunity. Boards of directors comply; the breakdown in corporate governance in this respect is complete.
The only fools here are the shareholders – and the rest of society that buys into such a foolhardy scheme.
An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.