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Executive Pay And Risk-Taking

The financial meltdown of 2008-2009 brought the attention of both the media and regulators back to the failure of corporate governance practices in general, but specifically on executive incentive systems which encourage risky investments. One of the most controversial issues is how executives are compensated and whether that impacted their risk-taking behaviors.

The outrage about executive pay was caused by the large pay-packages of some banking firms which eventually received bailout money from the federal government in the form of TARP money. CNN money has listed 2007 pay-packages of top executives from nine such banks. For example, in 2007 the total compensation for Kenneth Lewis of Bank of America was $24.8 million.

The role of incentives in risk-taking is even greater in the banking industry where the amount of debt is larger when compared with industrial firms. This is highlighted by the following article from Financial Times:

“The problem with this is that bankers are incentivised to seek bigger and riskier bets because volatility increases upside return without affecting downside risk. They are similarly encouraged to increase balance sheet leverage since this further magnifies the pay-off. And this incentive has been greatly reinforced by bonus targets related to return on equity – a classic inducement to short-term risk-taking.” By: John Plender, Financial Times, 25th Oct., 2011.

Critics of incentivized executive pay systems have proposed many ideas to curtail executive incentives in order to control the risk-taking behaviors. Such demands recur after every major economic crisis. For example, New York Times reported on March5, 1934 that Sen. Burton Wheeler complained about “Corporations in the red paying excessive salaries.” Recently, these proposals have been discussed across many countries. For example, in June 2010, U.S. regulatory agencies jointly issued the Final Guidance on Banking Incentive Compensation, designed to ensure that incentive compensation policies do not encourage imprudent risk taking in financial institutions. In last 3-4 years, countries like Canada, Germany and Holland have seen similar proposals. However, one needs to also consider other factors which have led to the growth in executive compensation and risk taking simultaneously. For example, the role of corporate boards which decide on how much to pay in what form to pay?

Corporate scandals of the last two decades or so have pushed board structures towards more independence from the management. The enactment of Sarbanes-Oxley Act (2002) and subsequent adoption of listing requirements by the national stock exchanges have made it mandatory to have a majority of independent directors. A push towards smaller and outsider dominated boards from the proponents of corporate governance reforms have significantly reduced the managerial representation on boards. These changes might have had impacted the quality of managerial evaluation and monitoring effectiveness of boards as outside board members rely on the insider directors for valuable information about a firm and its investments. In the absence of managerial inputs, outside board members could find it difficult to evaluate the quality of managerial decision making and may not design a compensation scheme that balances growth with risk taking.

We really need to understand whether the absence of these executive directors from the board room exacerbated the CEO power and hence the CEO pay-package and excessive risk taking. Without understanding these issues, we might end up adopting yet another defective system of executive incentives which almost certainly could expose us to the risk of another financial crisis.

Dr. Arun Upadhyay teaches finance courses in the College of Business at University of Nevada Reno. His primary teaching area is corporate finance. Before moving to academic world, Dr. Upadhyay worked for several years with a commercial bank in the area of credit analysis and international banking. He received Ph.D. in finance from Temple University. Prior to moving to University of Reno, he worked at University of Alaska Anchorage where he was awarded College of Business and Public Policy Best Teacher award. Dr. Upadhyay also served on the Investment Advisory Commission of Municipality of Anchorage.

Dr. Upadhyay’s research focuses on corporate governance issues. He studies corporate leadership structure and executive compensation. He has published articles on board structure in high quality finance journals such as Financial Management, Journal of Corporate Finance and Journal of Business Finance and Accounting. His work has been presented at various national and international conferences.