Monday, July 14, 2008

Regulating CEO pay

The furor over Fannie Mae and Freddie Mac and the current financial crisis in general has renewed interest in the compensation of the managers and CEOs of financial institutions:
Here is Angry Bear:
"OK so we have to bail out the FM's. However, it is irritating that the people who made this mess obtained tens of millions in compensation doing so. I can translate my populist rage into gametheoryspeak noting that bailouts create moral hazard problems. The US government can't let Fannie or Freddie or even the medium size bad Bear fail. It shouldn't make executives decide to run risks only because they know that if they roll snake eyes, the treasury or the fed will bail them out. So What is to Be Done ?It seems simple to me (and many many others). The institutions are too big to fail, their officers are vulnerable to bad incentives. The correct policy is to keep the institution from failing in a way which will serve as a lesson to the officers of other institutions."

On a more somber note, this was from a roundtable in Prospect Magazine:
"Hector Sants [chief executive of the FSA] said recently that the FSA would take account of bonus structures in firms in its prudential regulation. I think that makes perfect sense. No one is recommending a pay policy for banks in the 1970s style. But we need to think more about what a good bonus structure looks like and what a bad one looks like. And if you look at the credit rating agencies, they have hugely expanded on the back of structured credit. They have made lots of money out of these ratings and have had a strong incentive to stretch their models as far as possible to produce more ratings on a wide variety of products. So that is another example where the incentives embedded in the system need to be addressed."
These were the comments of John Gieve, deputy governor for financial stability of the Bank of England.

Trying to align CEO pay with shareholders have been the crux of organizational theory/principal-agent theory and unlike Angry Bear, I think that there are no easy answers. The general argument from the principal agent literature is that we don't want managers who are risk averse or risk loving but are risk neutral. Any attempt to regulate pay will result in a risk averse CEO or at the minimum turn him or her into a bureacrat that does the minimum to not attract the attention of regulators. In other words, we may be back to an era of regulated industries.

From NYT In Bailout Furor, Wall Street Pay Becomes a Target:
Wall Street has been the top tier of the corporate pay range, with executives earning eight-figure salaries. Its bonus system, which rewards short-term trading profits, has been singled out as an incentive for Wall Street executives to expand their highly profitable business in exotic securities and ignore the risks. ... “I’m of a free-market, conservative bent, but I am sympathetic to some reshaping of executive pay on Wall Street,” said Kenneth S. Rogoff, a professor of economics at Harvard. “For sure, I would consider very long-term payouts, up to 10 years out.”

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