Is Bankers’ Pay Really the Root of Financial Evil?

CHICAGO – Compensation practices at financial firms stand accused of being a primary cause of the recent global financial crisis. Restricting bankers’ pay is said to be the answer. But will such restrictions work?

Before instituting such invasive regulation, we should examine whether past compensation structures really were the catalysts for our recent problems. To say that they were implies three things: top bank executives were rewarded for short-term results with large amounts of up-front cash; bank executives did not hold sufficiently large amounts of stock to align their interests with those of shareholders; and executives with more short-term pay and less stock ownership should have had the greatest incentive to take bad and excessive risks, and thus should have performed worse in the crisis.

Two economists, Rudiger Fahlenbrach and Rene Stulz, tested these implications by studying the CEOs of almost 100 large financial institutions from 2006 to 2008. They start in 2006 because that seems to be the point at which some financial firms took on the risky positions that led to the crisis.

In 2006, the CEOs took home $3.6 million in cash compensation on average, which represented less than half of total compensation. The larger share of pay was in restricted stock and options. At the same time, they held an average of $88 million in their firms’ equity and options. In other words, they left more than 24 times as much in their firm as they took home. So it seems unlikely that this up-front cash provided much of an incentive for the average CEO to knowingly take bad or excessive risks that would jeopardize their much larger equity stakes.