The row over executive compensation has been reignited by the recent awarding of about £8 to 9m bonus to Bob Diamond, CEO of Barclays. Bob’s feisty defense of his bonus has further exasperated the many people who think that bankers are over-paid when we consider their ‘real’ performance. There have been a lot of debates following the subprime debacle about the impact of the compensation systems of senior executives and traders on their risk-taking behaviors. Many politicians and other opinion leaders have blamed pay practices at financial institutions for the excessive risk-taking that led to the Subprime disaster…

Is it a fair accusation? What is the real impact of compensation systems in financial institutions on risk-taking behaviors?

Let’s look at the data.. According to a study from Fahlenbrach & Stulz on the CEOs of almost 100 large financial institutions from 2006 to 2008. In 2006, the average CEO took home $3.6 million in cash on average, while holding $88 million worth of the firm’s equity (more than 24 times as much) loosing a large part of it during the crisis. Based on these data and the fact that CEOs ‘lost’ a lot of money too, the researchers make a big jump to conclude that bank “CEO incentives cannot be blamed for the credit crisis or for the performance of banks during that crisis.”

A friend of mine, a well-paid banker, once declared that:

“The recent ‘noise’ over of executive pay is due to the natural tendency for people to look for scapegoats when something goes wrong.. Most of those people are in fact envious of bankers and want to punish them. It is arbitrary vengeance unsupported by facts or theories.”

Really? Let’s explore further… and look at the facts more closely..

• Alan Fishman last CEO of Washington Mutual (WaMu) was paid US$19 million for 3 weeks of work in the company just before it collapsed
• Merrill Lynch’s chairman Stan O’Neal retired after announcing losses of $8bn, taking a final pay deal worth $161m.
• Citigroup boss Chuck Prince left the company with a $38m in bonuses, shares and options after multibillion-dollar write-downs.

This is just a few real examples among many more well publicized in the media that illustrates one disturbing reality…

1. In case of success, the senior management team and traders are ensured multi-million dollars bonuses
2. In case of failure, yes they have to ‘suffer’ some ‘paper loss’ BUT they can count on their past bonuses and often on other golden parachutes.

Hence in essence, there is LITTLE or NO personal real Downside Risk for senior executives and traders as they are in most cases essentially ‘immunized’ against the negative consequences of their bad decisions thanks to favorable compensations schemes. Even if they loose their jobs.., thanks to the short-term memory of the market, they will be back in the ‘circuit’ in no time once the economic situation improves!

For the Senior Executives and traders, it is like throwing a coin…

Head, I win! Tail, You Loose!.. As eventually the shareholders and tax payers will have to fork the bill.

As a result this situation, Moral Hazard can easily come into the picture! And hence we can conclude that YES it will lead to EXCESSIVE risk-taking by senior executives and traders.

I will explain the Agency Theory and the concept of ‘Moral Hazard’ that help understand the behavior of senior executives and traders in more details in my next post.