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How to Pay a Banker

CAMBRIDGE – The United States’ Federal Reserve Board recently adopted a policy under which bank supervisors, the guardians of the financial system’s safety and soundness, would review the compensation structures of bank executives. Authorities elsewhere are considering or adopting similar programs. But what structures should regulators seek to encourage?

It is now widely accepted that it is important to reward bankers for long-term results. Rewarding bankers for short-term results, even when those results are subsequently reversed, produces incentives to take excessive risks.

But tying executive payoffs to long-term results does not provide a complete answer to the challenge facing firms and regulators. The question still remains: long-term results for whom?

Equity-based awards, coupled with the highly leveraged capital structure of banks, tie executives’ compensation to a leveraged bet on the value of banks’ assets. As Holger Spamann and I show in our research, executive payoffs should be tied to the long-term value delivered not only to shareholders, but also to other contributors to banks’ capital. As it is, bank executives expect to share in any gains that might flow to common shareholders, but they are insulated from the consequences that losses, produced by their choices, could impose on preferred shareholders, bondholders, depositors, or the government as a guarantor of deposits.