INTRODUCTION AND LITERATURE REVIEW
The recent financial crises have resulted in both significant public pressure and government regulation to limit bankers' compensation. Politicians and the public press have decried the "outrageous" pay taken home by bankers during the recent economic troubles. Congress has enacted legislation to limit pay, and more specifically to limit the types of incentive pay.
In response to the banking crises and in part the public outrage at bankers' compensation during this period, Congress passed several sets of legislation to try and address this issue. In October of 2008, Congress passed the Emergency Economic Stabilization Act of 2008 (EESA), limiting the executive pay on those firms receiving TARP (Troubled Asset Relief Program) funds (Martin, Adkins and Oehmann III, 2009.) Additional limitations were added under the American Recovery and Reinvestment Act of 2009 (ARRA), which was enacted in February of that year; some of these proscriptions apply retroactively (Martin, et al., 2009). Both of these Acts were modified and updated since their introduction to try and better achieve their objectives.
Specific restrictions on executive compensation under these Acts included:
The limitation on the deductibility of executive compensation over $500,000 per executive.
Prohibitions on the payment of bonuses, retention awards, or incentive compensation, except for certain long-term stock awards. The value of the stock is not to exceed 1/3 of total annual compensation, and the stock may not vest until after all TARP-related obligations have been met. Restricted stock is exempt from the $500,000 annual compensation limitation.
The disclosure and justification for perquisites over $25,000 paid to any executive.
Limits on compensation that excludes incentives for executives to take "excessive risks", which is to be implemented by compensation committee review of incentive programs. (McGuireWoods white paper)
These restrictions apply as long as any obligations from any TARP financial assistance remain outstanding.
In addition, to the strict legal requirements singling out the TARP-affected firms, other, more subtle (or not-so-subtle), pressures were put on the banking industry to limit pay. Kenneth Feinberg, Treasury master for executive compensation (Obama's "pay czar") proclaimed that nearly 80% of $2 billion in 2008 banker bonuses was unmerited, and that the criteria used to award the bonuses was "haphazard." (New York Times, July 23, 2010, Eric Dash) He therefore pushed boards to use more stock and less cash in their compensation packages. This was intended to limit excessive risk-taking. Towards this objective, he also promoted the use of more deferred compensation with a vesting time-frame of 3-5 years.
Fahlenbrach and Stulz (2011) nicely summarize the arguments made for regulating incentive compensation. "The argument seems to be that executives' compensation was not properly related to long-term performance ...,"(p. 11) "... CEOs had strong incentives to focus on the short run instead of the long run. Another version [of the poor incentives argument] is that option compensation gave incentives to CEOs to take more risks than would have been optimal for shareholders, (p. 12.) They note that previous studies find that bank executives receive less of their pay in the form of stock and options (and therefore more in cash) than in other industries. (Adams and Mehran, 2003, Houston and James, 1995.)
THE PURPOSE OF THIS STUDY
We wish to examine whether indeed the compensation restrictions have had their intended effect of altering the composition of banking executives' compensation. Did the EESA, ARRA, and related compensation regulations, along with the accompanying public and political pressure, result in the managers' compensation packages being altered to promote better long-term decision-making and to discourage unnecessary risk-taking? To attempt to answer these questions, we will test the following three hypotheses:
H1 The relative use of cash-based incentive compensation has declined in response to the regulations.
H2 The relative use of stock-based incentive compensation has increased in response to the regulations.
H3 The relative use of option-based incentive compensation has declined in response to the regulations.
The logic behind HI, as noted above, is that current cash-based compensation, which by definition will not be dependent on future stock performance, will cause managers to focus more on the short term and less on the long term. This is exacerbated by the fact that cash-based incentives are often based on short-term performance measures, and are often based on accounting, not stock, measures (such as ROE or EPS growth.) A complimentary argument is that if more wealth is cash-based, the manager may undertake excessively risky projects since the stock wealth effects are less relevant. Therefore, if the Acts have their intended effect on compensation, we should see the relative use of cash-based incentives decline.
The logic behind H2 of course is that the more stock-based compensation the manager receives, the more he will make decisions considering the long-term implications of his actions; the more he will align his interests with those of his shareholders. Practically, the Acts encourage the use of restricted stock to achieve this purpose.
The logic behind H3 is that it is argued that the "overuse" of options also leads to excessive risk-taking by managers. Since the options are more volatile than the underlying stock, and the manager is only concerned with upside volatility of the option, the manager will take on excessively risky projects in order to take advantage of the option's upside volatility. Therefore the restrictions and pressures on banking compensation should lead to the relative reduction in the use of options.
These three hypotheses will be tested using the sample described below.
DATA, SAMPLE, AND METHODOLOGY
The sample for this study consists of bank CEOs and their second-in-commands for the largest U.S. banking institutions. We used Capital IQ to identify the largest "Banks (Primary)" and "Diversified Financials (Primary.)" This specification includes commercial banks such as Wells Fargo, and the financial institutions engaging in both commercial and investment banking such as JPMorgan Chase. We want to include the types of banking institutions that were affected by the compensation regulations initiated in response to the financial crisis. Our initial sample included the 50 largest institutions based on total assets in fiscal year 2010. The largest firm in our final sample (JPMorgan Chase) had total assets of $2.1 trillion, and the smallest bank had assets of just over $16 billion. For practical purposes our sample includes the bulk of the firms most affected by the compensation restrictions. By dollar value, our sample includes the firms with about 50% of total (commercial) banking assets for the fiscal year 2010 $6.05 trillion of $12 trillion in commercial banking assets, (www.federalreserve.gov) Note that our sample excludes a few of the major firms significantly impacted by the compensation regulations, such as AIG (insurance) and Chrysler Acceptance Corporation (vehicle financing.) While these firms were significantly impacted by the regulations, they do not have banking functions in the strictest sense, which is our focus. Additionally, the company must have common stock traded on a public U.S. exchange. This requirement ensures that the compensation information will be publicly available in the firm's annual proxy statement.
The sample period for this study includes the fiscal years 2007-2010. The most significant of the compensation restrictions were put in place in 2008-2009. Therefore we've included the "before, during and after" period of incentive compensation...