The Uneasy Case for Deferring Banker Pay

• Author: Eric D. Chason
• Position: Associate Professor of Law, William & Mary Law School
• Pages: 923-977

The Uneasy Case for Deferring Banker Pay

Eric D. Chason*

TABLE OF CONTENTS

I. Introduction ..........................................................................924

II. Systemic Risk and the Goal of Financial Regulation ............928

A. Financial Intermediation ................................................... 928

B. The Fire-Sale Externality and Systemic Risk ..................931

C. Regulation and Support of Systemically Important

Institutions ......................................................................935

1. Bank Activities .........................................................935

2. Capital Adequacy .....................................................936

3. Deposit Insurance .....................................................937

4. Discount Window and Other Lending Facilities .......938

5. Bank Creditor Bailouts .............................................939

III. Post-TARP Movement to Regulate Banker Pay ...................940

A. Introduction ....................................................................940

B. Dodd–Frank’s Unfocused Compensation Reforms .........941

1. Compensation Reforms of General Application .......941

2. FDIC Clawback Authority ........................................942

3. Compensation at Covered Financial Institutions .......944

C. The Financial Stability Board (FSB) ...............................945

D. FSB Principles for Sound Compensation Practices .........946

1. The Risk-Management Criticism of Incentive

Compensation ...........................................................946

2. Alignment of Incentive Compensation with Risk

Management .............................................................947

3. Governance by Boards, Regulators, and

Stakeholders .............................................................950

E. FSB Implementation Standards ......................................951

F. U.S. and E.U. Implementation of Compensation

Reform ............................................................................952

Copyright 2013, by ERIC D. CHASON.

* Associate Professor of Law, William & Mary Law School.

924 LOUISIANA LAW REVIEW [Vol. 73

IV. Moral Hazard and Compensation Reform ............................953

A. Moral Hazard Versus Systemic Risk ..............................953

B. Financial Background .....................................................954

1. Investing Versus Financing ......................................954

2. An Example Comparing Return on Assets and

Return on Equity .......................................................955

C. Cause and Effects of Moral Hazard ................................957

1. Creditor Protections .................................................957

2. Incentive for Additional Risk ....................................958

3. Incentive for Additional Debt Financing ..................959

D. Compensation-Reform Proposals ...................................960

V. Debt-Based Compensation Examined ..................................962

A. Limits of Debt-Based Compensation ..............................962

1. Control of Managers’ Incentives to Pursue

Uncompensated Investment Risk .............................962

2. Failure to Control Systemic Risk ..............................963

3. Failure to Control Incentives of Outside

Shareholders .............................................................966

B. The Public Safety Net and the Dubious Threat of

Default Risk ....................................................................967

C. Incentive for Even Greater Risk-Taking with

Implicit Leverage ............................................................971

D. The Weak Incentives of Perfect Debt-Based

Compensation .................................................................974

VI. Conclusion ............................................................................977

I. INTRODUCTION

Popular outrage against “greedy bankers” and the “bonus

culture” on Wall Street has energized a new movement to regulate

banker pay. Yet, concern about banker pay extends beyond Occupy

Wall Street and newspaper editorials, as academics, policymakers,

and even bankers themselves believe that pay practices contributed

to the financial crisis of 2007–2009.1 Bankers receive much of their

1. The Institute for International Finance commissioned an industry survey

in which “98% of survey respondents believe that compensation structures were a

factor underlying the crisis.” INST. OF INT’L FIN., COMPENSATION IN FINAN CIAL

2013] DEFERRING BANKER PAY 925

ample compensation in bonuses, which are determined by annual

performance. The standard critique argues that poorl y designed

bonus plans encouraged bankers to pursue risks that were

inconsistent with long-term shareholder value and the stability of

financial markets.2 Aligning the incentives of bankers with the

interests of their shareholders and society now commands

significant attention from policymakers and academics.3 Some

proposals offer a soft, “principles-based” approach that is unlikely to

do much harm (or good).4 Others, however, would regulate the form

in which bankers are paid.

The basic forms implicated are fairl y conventional: current

salaries and bonuses (i.e., paychecks), equity compensation, and

deferred compensation. Equity compensation is usually a grant of

the employer’s stock (e.g., shares worth $1 million) or an option to

buy such stock. Deferred compensation is essentially debt. Rather

than paying cash today, the emplo yer promises to pay the employee

SERVICES: INDUSTRY PROGRESS & THE AGENDA FOR CHANGE 2 (2009). See also

FIN. STABILITY FORUM, FSF PRINCIPLES FOR SOUND COMPENSATION PRACTICES 4

(2009) [hereinafter FSF PRINCIPLES], available at http://www.financialstability

board.org/publications/r_0904b.pdf (“Multiple surveys find that over 80 percent of

market participants believe that compensation practices played a role in promoting

the accumulation of risks that led to the current cri sis.”).

2. See FSF PRINCIPLES, supra note 1, at 7–8; U.S. DEP’T OF THE TREASURY,

FINANCIAL REGULATORY REFORM—A NEW FOUNDAT ION: REBUILDING

FINANCIAL SUPERVISION AND REGULATION 29 (2010), http://www.treasury.gov

/initiatives/Documents/FinalRe port_web.pdf (“Among the many significant causes

of the financial crisis were compensation practices. In particular, ince ntives for

short-term gains overwhelmed the checks and bala nces meant to mitigate against

the risk of excess leverage. We will seek to better align c ompensation practices

with the interests of shareholders and t he stability of firms and the financial system

. . . .”).

3. See generally Frederick Tung, Pay for Banker Performance: Structuring

Executive Compensation for Risk Regulation, 105 NW. U. L. REV. 1205 (2011);

Claire Hill & Richard Painter, Berle’s Vision Beyond Shareholder Interests: Why

Investment Bankers Should Have (Some) Personal Liability, 33 SEATTLE U. L.

REV. 1173 (2010); Guido Ferrarini & Maria Cristina Ungureanu, Economics,

Politics, and the International Principles for Sound Compensation Practices: An

Analysis of Executive Pay at European Banks, 64 VAND. L. REV. 431 (2011); Karl

S. Okamoto & Douglas Edwards, Risk-Taking, 32 CARDOZO L. REV. 159 (2010);

Lucian A. Bebchuk & Holger Spamann, Regulating Bankers’ Pay, 98 GEO. L.J.

247 (2010); Lucian A. Bebchuk, Alma Cohen & Holger Spamann, The Wages of

Failure: Executive Compensation at Bear Stearns and Lehman 2000–2008, 27

YALE J. ON REG. 257 (2010); Sanjai Bhagat & Roberta Romano, Reforming

Executive Compensation: Focusing and Committing to the Long-Term, 26 YALE J.

ON REG. 359 (2009).

4. See FSF PRINCIPLES, supra note 1. See also generally FIN. STABILITY BD.,

CHARTER OF THE FINANCIAL STABILITY BOARD (2012), available at http:

//www.financialstabilityboard.org/publications/r_120809.pdf.