Wednesday, November 24, 2010

How to Fix Bankers’ Pay

Via Harvard Law School Forum. 

This essay – written for a special issue of the American Academy of Arts and Sciences’ Daedalus journal on lessons from the financial crisis – discusses how bankers’ pay should be fixed. I describe two distinct sources of risk-taking incentives: first, executives’ excessive focus on short-term results; and, second, their excessive focus on results for shareholders, which corresponds to a lack of incentives for executives to consider outcomes for other contributors of capital. I discuss how pay arrangements can be reformed to address each of these problems and conclude by examining the role that government should play in bringing about the needed reforms. The essay provides an accessible summary of the analysis developed in Bebchuk and Fried, “Paying for Long-Term Performance” (University of Pennsylvania Law Review, 2010) and Bebchuk and Spamann, “Regulating Bankers’ Pay” (Georgetown Law Journal, 2010).

To address the problem of short-term focus, financial firms should reform compensation structures to ensure tighter alignment between executive payoffs and long-term results. Senior executives should not be able to collect and retain large amounts of bonus compensation when the performance on which the bonuses are based is subsequently sharply reversed. Similarly, equity incentives should be subject to substantial limitations aimed at preventing executives from placing excessive weight on their firm’s short-term stock price. Had such compensation structures been in place at Bear Stearns and Lehman, their top executives would not have been able to derive such large amounts of performance-based compensation for managing these firms in the years leading up to their collapse.

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