The Pay Structure for Executives Creates Bad Incentives
Stephen LeRoy, a professor emeritus at the University of California, Santa Barbara, and a visiting scholar at the Federal Reserve Bank of San Francisco, explains why the pay structure for CEOs creates bad incentives. The key to his argument is the following graph:
Figure 1
The concept of convex compensation
The graph shows that traders receive a higher payoff when returns are high as opposed to when they are low, and this is the source of the perverse incentive. Stephen LeRoy explains:
What this means in practice is that bonuses and options packages have the property that the trader who does extremely well can look forward to a multimillion-dollar bonus but is not penalized millions of dollars when he or she does badly. Similarly, the recipient of an options package experiences a large windfall when the price of the company's stock increases. But if the stock does extremely badly, he or she pays no penalty relative to the case when the stock drops modestly.The bowed shape of the payoff function is called a "convex payoff." It is the bowed shape that creates the bad incentives, specifically the incentive to take on too much risk:
convex payoff functions distort the incentives of financial practitioners. Specifically, they induce a motive to gamble. If paid according to a convex function, an executive may earn more money on average during a mixture of high revenue years and low revenue years than he or she would under a succession of moderate revenue years, even if average revenue is higher in the latter case. The executive is therefore motivated to adopt risky financial strategies. Sometimes these risks work out and sometimes they don't. But high income in good years more than offsets low income in bad years.
The stockholders of financial firms--or, in cases in which government support is extended, taxpayers--have the opposite payoff. They benefit from a fraction of the gains, but bear all the losses. Therefore they may be made worse off by a risky investment strategy even if the strategy itself has favorable odds. Convex payoffs create what is called an "agency problem." The executives have interests that diverge from those of the stockholders, for whom they are supposedly working.What specific problem are associated with the incentive to take on too much risk? There are both political and economic problems. On the political front:
the use of taxpayer money to pay multimillion-dollar bonuses and award outsized options packages to senior executives and successful traders at institutions receiving government support, which includes most large financial institutions, has sparked widespread public revulsion.As for the economic issues, LeRoy notes three, excessively risk investments, excessive leverage, and concentrated rather than distributed risk, all of which were problems that contributed to the severity of the crisis (there is more detail on these problems in the article).
Regulators appear to be aware of this problem, but will they fix it? The Economic Letter ends on a rather pessimistic note:
The regulatory system, including the Federal Reserve, is currently implementing guidelines designed to mitigate the problems discussed in this Letter. However, there is no consensus on the question of how much government intervention in the determination of compensation is appropriate. It remains to be seen whether the new regulations will substantially improve the situation.I don't believe that fixing this problem will, by itself, prevent future crises, but it does need to be part of a comprehensive prevention package. However, even so, it remains to be seen if regulators and legislators will go against he considerable power within the industry and impose the restrictions that are needed. Given how much power and influence the big banks have presently, I'm not certain that will happen.
