Bank Executive Compensation
and
Capital Requirements Reform
Sanjai Bhagat
Brian Bolton
University of Colorado
Portland State University
2012 Conference on
Corporate Governance of Financial Institutions
Bank of Netherlands / University of Groningen
November 8-9, 2012
From Lehman Brothers’ 2005 Annual Report
“The Lehman Brothers standard
means…fostering a culture of ownership,
one full of opportunity, initiative and
responsibility, where exceptional people
want to build their careers.”
From Goldman Sachs’ 2002 Annual Report
“The core of the Goldman Sachs
partnership was shared long-term
ownership…By making all of our people
owners, the firm would benefit by
strengthening the culture of ownership”
From Goldman Sachs’ 2006 & 2007 Proxies
Goldman Sachs grants “Long-Term
Compensation Awards” with Restricted
Stock Units.
From 2004-2006, 40% of all “Restricted
Stock Units” vested immediately.
In 2007, 100% of all “Restricted Stock
Units” vested immediately
(including grants from prior years).
From Goldman Sachs’ 2006 & 2007 Proxies
Goldman Sachs grants “Long-Term
Compensation Awards” with Restricted
Stock Units.
From 2004-2006, 40% of all “Restricted
Stock Units” vested immediately.
In 2007, 100% of all “Restricted Stock
Units” vested immediately
(including grants from prior years).
From Goldman Sachs’ 2006 & 2007 Proxies
Goldman Sachs grants “Long-Term
Compensation Awards” with Restricted
Stock Units.
From 2004-2006, 40% of all “Restricted
Stock Units” vested immediately.
In 2007, 100% of all “Restricted Stock
Units” vested immediately
(including grants from prior years).
Motivation: Incentives Matter
• Bebchuk, Cohen & Spamann (2010)
• Clinical analysis of the executive compensation
structures at Bear Stearns and Lehman Brothers
• “…given the structure of executives’ payoffs, the
possibility that risk-taking decisions were
influenced by incentives should not be dismissed
but rather taken seriously”
Bank Executive Compensation and Capital Requirements Reform
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Motivation: Incentives Do Not Matter
• Fahlenbrach & Stulz (2011)
• Larger sample analysis of losses experienced by
financial institution CEOs during the crisis,
based on their ownership of company stock
• The poor performance of banks is attributable to
an extremely negative realization of the high risk
nature of their investment and trading strategy
• “…Bank CEO incentives cannot be blamed for
the credit crisis or for the performance of banks
during that crisis”
Bank Executive Compensation and Capital Requirements Reform
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Investment Scenario #1
Consider the following investment strategy:
• 6 possible cash flow outcomes
– 5 outcomes of +$500 million
– 1 outcome of –$5 billion
– Each with equal probability
• Investment strategy has a negative NPV
• Probability and magnitude of the cash flows are
known only to the bank executives
• Should the bank invest in this project?  NO
Bank Executive Compensation and Capital Requirements Reform
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Investment Scenario #2
However, the investing public is led to believe that
the trading strategy leads to the following:
• 6 possible cash flow outcomes
– 5 outcomes of $500 million
– 1 outcome of –$1 billion (not $5 billion as before)
– Each with equal probability
• Investment strategy has a positive NPV
• Should the bank invest in this project?  YES
Stock price goes up, managers potentially liquidate shares and take
money off the table since they know the true outcomes
Bank Executive Compensation and Capital Requirements Reform
Amsterdam 2012
“Managerial Incentives Theory”
• 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.
• Testable Implications:
– Managers are acting in own self interest, sometimes
dissipating long-term shareholder value
– Net Manager Payoff during and prior to financial crisis
period should be positive
Bank Executive Compensation and Capital Requirements Reform
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“Unforeseen Risk Hypothesis”
• Bank executives were faithfully working in the interests of
their long-term shareholders; the poor performance of their
banks during the financial crisis was the result of the bank’s
investment and trading strategy.
• Testable Implications:
– Managers are consistently acting to enhance long-term
shareholder value
– Net Manager Payoff during and prior to financial crisis
period should be negative
Bank Executive Compensation and Capital Requirements Reform
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Data & Setting
Analysis of stock, option and compensation structures at 100 of the largest
U.S. financial institutions from 2000-2008
The Sample: 3 Main Subsamples:
1. TBTF – “Too Big Too Fail”





14 firms
9 original firms required to take TARP funding in October 2008
Bank of America
Merrill Lynch
Bank of New York Mellon
Morgan Stanley
Citigroup
State Street
Goldman Sachs
Wells Fargo
JP Morgan Chase
Bear Stearns and Lehman Brothers – likely would have been included had they
been independent going concerns in October 2008
Mellon Financial and Countrywide – acquired by Bank of New York and Bank of
America just prior to (or during) the crisis
AIG, American International Group
Bank Executive Compensation and Capital Requirements Reform
Amsterdam 2012
Data & Setting
Analysis of stock, option and compensation structures at 100 of the largest
U.S. financial institutions from 2000-2008
The Sample: 3 Main Subsamples:
1. TBTF – “Too Big to Fail”
2. L-TARP – “Late TARP”


49 firms
Using the sample of financial institutions provided in Fahlenbrach and Stulz (2011),
we identify those institutions that eventually received funding through TARP
3. No-TARP – “No TARP”


37 Firms
Using the sample of financial institutions provided in Fahlenbrach and Stulz (2011),
we identify those institutions that never received funding through TARP
Bank Executive Compensation and Capital Requirements Reform
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Data: Sources
• Insider trading data from Form 4 filings
– Obtained from Thomson Insiders’ database and actual
filings on SEC website
• Insider and director ownership from proxy statements
– Obtained from RiskMetrics and from actual filings on SEC
website
• Insider compensation data from 10-K and proxy
statements
– Obtained from Compustat Execucomp and from actual
filings on SEC website
• Financial and stock price data from Compustat & CRSP
Bank Executive Compensation and Capital Requirements Reform
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Data: Key Variables
(1)
+
–
–
=
Value of Stock Sales
Value of Stock Buys
Value of Option Exercises
Value of Net Trades
(2)
+ Value of Net Trades
+ Value of Salary & Bonus Compensation
– Unrealized Value Lost
.
= Value of Net CEO Payoff
Bank Executive Compensation and Capital Requirements Reform
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TBTF Data: CEO Trade Information
Trades by TBTF CEOs, 2000-2008 (Table 3A)
Total # of Sales
Total # of Buys
Total # of Option Exercises
2,048
73
470
+ Value of Sales
– Value of Buys
– Value of Option Exercises
$3,467,411,569
$ 36,400,641
$1,659,607,191
Value of Net Trades
$1,771,403,737
 $1.77 billion of cash taken off the table by bank executives
(High of $428m at Lehman Brothers
Bank Executive Compensation and Capital Requirements Reform
Low of -$7m at AIG)
Amsterdam 2012
TBTF Data: CEO Trade Information
Total CEO Payoff by TBTF CEOs, 2000-2008 (Table 4A)
+ Value of Net Trades
+ Total Cash Compensation
+ Realized Cash Payoffs to CEO
$1,771,403,737
$ 891,237,300
$2,662,641,037
– Unrealized Paper Loss, 2008
$2,013,683,157
Net CEO Payoff: 2000-2008
$ 648,957,880
(High of $377m at Countrywide
Low of -$311m at Lehman – but CEO Dick Fuld
had already realized cash of over $400m)
Estimated Value Remaining, 2008 $ 939,328,179
Bank Executive Compensation and Capital Requirements Reform
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Trade Information:
TBTF, L-TARP & No-TARP CEOs
Ratio of Trades to
Ratio of Trades to
Beginning Holdings: Beginning Holdings:
2000-2008
2004-2008
Total Net Trades:
2000-2008
Total Net Trades:
2004-2008
$126,528,838
$80,892,620
103.4% ***
23.4% **
$66,842,520
$32,602,548
59.7% ***
11.8%
Mean
$5,724,901
$3,158,121
100.4% ***
10.2% *
Median
$1,090,134
$561,761
17.6% *
3.5%
$11,826,280
$9,107,443
43.9%
-1.3%
$1,226,977
$32,818
4.0%
0.1%
TBTF Firms (n=14)
Mean
Median
L-TARP Firms (n=49)
No-TARP Insituttions (n=37)
Mean
Median
Bank Executive Compensation and Capital Requirements Reform
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Trade Information:
TBTF, L-TARP & No-TARP CEOs
Ratio of Trades to
Ratio of Trades to
Beginning Holdings: Beginning Holdings:
2000-2008
2004-2008
Total Net Trades:
2000-2008
Total Net Trades:
2004-2008
$126,528,838
$80,892,620
103.4% ***
23.4% **
$66,842,520
$32,602,548
59.7% ***
11.8%
Mean
$5,724,901
$3,158,121
100.4% ***
10.2% *
Median
$1,090,134
$561,761
17.6% *
3.5%
$11,826,280
$9,107,443
43.9%
-1.3%
$1,226,977
$32,818
4.0%
0.1%
TBTF Firms (n=14)
Mean
Median
L-TARP Firms (n=49)
No-TARP Insituttions (n=37)
Mean
Median
Bank Executive Compensation and Capital Requirements Reform
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Net CEO Payoffs:
TBTF, L-TARP & No-TARP CEOs
Total Net
Trades: 20002008
(A)
Total Cash
Compensation:
2000-2008
(B)
CEO Payoff:
2000-2008
(A)+(B)
Estimated Value Net CEO Payoff:
Lost: 2008
2000-2008
(C)
(A)+(B)+(C)
$126,528,838
$66,842,520
$63,659,807
$65,645,943
$190,188,646
$144,938,011
($143,834,511)
($78,475,455)
$46,354,134
$19,490,420
L-TARP Firms (n=49)
Mean Values
Median Values
$5,724,901
$1,090,134
$11,778,980
$10,437,874
$17,503,880
$12,256,013
($13,506,398)
($3,985,288)
$3,997,482
$5,208,903
No-TARP Firms (n=37)
Mean Values
Median Values
$11,826,280
$1,226,977
$10,707,257
$8,400,500
$22,533,537
$9,279,892
($18,131,515)
($5,397,493)
$9,792,473
$5,728,988
TBTF Firms (n=14)
Mean Values
Median Values
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Stock Returns: 2000-2008
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Abnormal Stock Returns
Bank Executive Compensation and Capital Requirements Reform
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Summary of Results
• Bank executives at these 14 institutions took billions of
dollars ‘off-the-table’ from 2000-2008, yet shareholders
most likely lost considerable amounts of money
– Consistent with our Managerial Incentives hypothesis
• Yes, they did lose considerable sums in the crash of
2008...But, the 2008 paper losses were far less than the
cash already realized from compensation and sales
– Inconsistent with our Unforeseen Risk Hypothesis
• Bank executives’ compensation was not aligned with
the returns shareholders received during 2000-2008 or
with the risks the firms took
Bank Executive Compensation and Capital Requirements Reform
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Additional Analyses
• Findings hold for 2001-2008, 2002-2008 & 2004-2008 subperiods
• Findings hold for firms that had only 1 CEO throughout the
sample period (TBTF=4, L-TARP=22, No-TARP=17)
• Similar findings for sample of All Insiders, including
officers and directors
• TBTF experienced the largest write-downs and had the
lowest Z-Scores – consistent with Gande & Kalpathy
• Ratio of Net Trades to Concluding Holdings
– Highest at TBTF firms, lowest at No-TARP firms
• Annual Net Trades to Beginning of Year Holdings
– Highest at TBTF firms, lowest at No-TARP firms
Bank Executive Compensation and Capital Requirements Reform
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From The World of Phsyics
“The problems that exist in the world
today cannot be solved by the thinking
that created them.”
~ Albert Einstein
Restricted Equity Proposal
Proposal to reform executive compensation
• Annual cash compensation:
$2 million limit
• Executive incentive compensation plans should consist
only of:
– Restricted stock & Restricted stock options
– This compensation would be “restricted” in the sense
that the shares cannot be sold and the options cannot be
exercised for a period of 2-4 years after the executive’s
resignation or last day in office
• “Super-Escrow” with time & performance vesting elements
Bank Executive Compensation and Capital Requirements Reform
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Restricted Equity Proposal
• Proposal will provide superior incentives compared to
unrestricted stock and options plans for executives to:
1. Manage corporations in investors’ longer-term interest;
2. Diminish their incentives to attempt to achieve shortterm stock price appreciation by:
• Making aggressive public statements about
performance or investments
• Manage earnings
• Accept undue levels of risk
Bank Executive Compensation and Capital Requirements Reform
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following provisions:
From ExxonMobil’s 2012 Annual Report
Executive stock grants are subject to the
following vesting provisions:
1. 50% of each grant is unvested for 5 years;
2. 50% of each grant is unvested for 10 years
or until retirement – whichever is later.
(This has been the policy since 2002, when restricted
stock was granted to more than 5,300 employees)
Bank Executive Compensation and Capital Requirements Reform
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Caveats #1: Under-diversification
• Under-diversification: If executives are required to hold
restricted shares and options they would most likely be
under-diversified
• Problem: This lowers the risk-adjusted expected return for
the executive
• Solution: Grant additional compensation to the executive
– Would require some prohibition against engaging in creative
derivative transactions (such as equity swaps) or borrowing
arrangements that would hedge the payoff from the restricted
shares/options
Bank Executive Compensation and Capital Requirements Reform
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Caveats #2: Liquidity
• Lack of liquidity of executives’ compensation
• Problem: Given that the average tenure of these CEOs is
about 5 years, a CEO may have to wait 7-9 years before
being allowed to sell shares/options and realize their
incentive compensation
• Solution: Allow sale or exercise of some portion of the
executive’s portfolio, possibly 5-15% of their shares/options
– But, for some CEOs, this could be $100+ million in sales
– Limit the annual ownership position liquidations to a dollar amount
of $5-10 million
Bank Executive Compensation and Capital Requirements Reform
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2 Key Points
1. We are not advocating more compensation-related regulation
• Boards of directors, not regulators, should determine:
The mix and amount of restricted stock and restricted stock
options a manager is awarded
The percentage and dollar amount of holdings a manager can
liquidate each year, prior to retirement
The number of years post-retirement/resignation required for
the stock and options to vest.
2. This need not reduce executive compensation
• The net present value of all salary and stock compensation can
be higher than historical levels, so long as the managers invest
in projects that lead to long-term value creation
• This proposal limits annual cash amounts, not total amounts
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Caveats #3: Capital Structure
• Banks should be financed with considerable more equity
than they are being financed with currently
• Solutions based on equity-based incentives for executives
• High current levels of debt (~90-95%) will magnify
losses
– Note Bear and Lehman were at 3-4% in 2008
• As a bank’s equity value approaches $0 – as the did for
some banks in 2008 – equity based incentive programs
lose their effectiveness in motivating managers to
maximize shareholder value
Bank Executive Compensation and Capital Requirements Reform
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Caveats #3: Capital Structure
• Banks should be financed with considerable more equity
than they are being financed with currently
TBTF Firms
7.01% equity in 2007
L-TARP Firms
9.80% equity in 2007
No-TARP Firms
10.17% equity in 2007
• For the corporate sector as a whole, the debt ratio is about
47% (53% equity)
• Since high current levels of debt will only magnify
losses, banks need to adjust their equity levels to become
more like the corporate sector as a whole for equity
incentive programs to be effective in bad economic times
Bank Executive Compensation and Capital Requirements Reform
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Conclusion
• Clinical analysis of the cash compensation received by
CEOs at 14 large financial institutions shows that their
interests were not properly aligned with shareholders’
– They had incentives to maximize short-term gains and cash-out at
the expense of long-term value creation
– Behavior by directors was just as bad, if not worse
• When compared to 86 other financial institutions, we
observe the same tendencies:
– TBTF sample showed the greatest misalignment
– L-TARP sample showed substantial misalignment
– No-TARP sample showed best relative alignment
Bank Executive Compensation and Capital Requirements Reform
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Conclusion
• Incentive compensation plans should use only stock and
options that cannot be converted to cash for 2-4 years after
the CEO leaves the firm
– Limits on annual cash compensation
– CEOs can sell some annually for liquidity purposes
– Similar structure should apply to directors and other executives
• In order for equity incentives to be effective, banks need to
be financed with more equity than they currently are:
possibly on the order of 20-30% or more
• These compensation recommendations do not necessarily
apply to just financial institutions
• Objective is to prevent executives from taking short-term
motivated risks at the expense of long-term value creation
Bank Executive Compensation and Capital Requirements Reform
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