Sanjai Bhagat and Brian J. Bolton study the executive compensation structure in the largest 14 U.S. financial institutions during 2000-2008 for their paper, Investment Bankers’ Culture of Ownership? Their results are mostly consistent with and supportive of the findings of Bebchuk, Cohen and Spamann (2010), that is, managerial incentives matter – incentives generated by executive compensation programs led to excessive risk-taking by banks leading to the current financial crisis.
They refer to this as the Managerial Incentives Hypothesis: Incentives generated by executive compensation programs led to excessive risk-taking by banks leading to the current financial crisis; the excessive risk-taking would benefit bank executives at the expense of the long-term shareholders.
Their results are generally not supportive of the conclusions of Fahlenbrach and Stulz (2009) that the poor performance of banks during the crisis was the result of unforeseen risk. They refer to this as the Unforeseen Risk Hypothesis: Bank executives were faithfully working in the interests of their long-term shareholders; the poor performance of their banks during the crisis was the result of unforeseen risk of the bank’s investment and trading strategy.
The authors recommend the following compensation structure for senior bank executives:
- 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.
- However, managers should be permitted to annually liquidate about 5% to 15% of their ownership positions, but these annual ownership position liquidations should be restricted to an amount of $5 million to $10 million.
- This compensation structure will provide managers stronger incentives to work in the interests of long-term shareholders, and avoid excessive risk-taking.
While their focus is on banks, corporate board compensation committees of firms in other industries should also give the above executive incentive compensation structure serious consideration say the authors. Additionally, they suggest that directors should adopt a similar incentive compensation structure with regard to their own incentive compensation.