The Uneasy Case for Deferring Banker Pay

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

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