Bank Executive Compensation
And
Capital Requirements Reform
Sanjai Bhagat
University of Colorado
Brian Bolton
University of New Hampshire
International Monetary Fund
Washington, DC
March 16, 2012
Motivation: Incentives Matter
• Bebchuk, Cohen & Spamann (2010)
• Clinical analysis of the executive compensation
structures at Bear Stearns and Lehman Brothers
• “…given the structure of executives’ payoffs, the
possibility that risk-taking decisions were
influenced by incentives should not be dismissed
by rather taken seriously”
Motivation: Incentives Do Not Matter
• Fahlenbrach & Stulz (2009)
• Large sample analysis of losses experienced by
financial institution CEOs during the crisis,
based on their ownership of company stock
• The poor performance of banks is attributable to
an extremely negative realization of the high risk
nature of their investment and trading strategy
• “…Bank CEO incentives cannot be blamed for
the credit crisis or for the performance of banks
during that crisis”
Investment Scenario #1
Consider the following investment strategy:
• 6 possible cash flow outcomes
– 5 outcomes of $500 million
– Sixth outcome is a random loss that increases over time
• Sixth outcome = -$(0.5 + e)(t) billion; for t between years t1 and t2, and
• Sixth outcome = -$(0.5 + e)(t2) billion; for t greater than t2 years,
– Each with equal probability
• Investment strategy has a negative NPV
• Probability and magnitude of the cash flows are known only to the
bank executives
• Should the bank invest in this project?  NO
Investment Scenario #2
Given the information disclosed to the investing public, the stock market is led to
believe that the trading strategy can lead to the following:
• 6 possible cash flow outcomes
– 5 outcomes of $500 million
– Sixth outcome is a random loss
• Sixth outcome = -$(0.5 + e) billion
– Each with equal probability
• Given the information disclosed to the investing public, above investment
strategy has a positive NPV
Bank invests in project.
Share price goes up.
Managers liquidate shares … take money off the table.
Managerial Incentives Hypothesis
• Incentives generated by executive compensation programs led
to excessive risk-taking by banks leading to the current
financial crisis;
the excessive risk-taking would benefit bank executives at the expense of
the long-term shareholders.
• Consistent with Bebchuk, Cohen & Spamann (2010)
• Testable Implications:
– Managers are acting in own self interest, sometimes
dissipating long-term shareholder value
– Net Manager Payoff during and prior to financial crisis
period should be positive
Unforeseen Risk Hypothesis
• Bank executives were faithfully working in the interests of
their long-term shareholders; the poor performance of their
banks during the financial crisis was the result of the bank’s
investment and trading strategy.
• Consistent with Fahlenbrach & Stulz (2009)
• Testable Implications:
– Managers are consistently acting to enhance long-term
shareholder value
– Net Manager Payoff during and prior to financial crisis
period should be negative
Data & Setting
Analysis of stock, option and compensation structures at 14 of the largest
U.S. financial institutions from 2000-2008
The Sample:
• 9 original firms required to take TARP funding in October 2008
Bank of America
Merrill Lynch
Bank of New York Mellon
Morgan Stanley
Citigroup
State Street
Goldman Sachs
Wells Fargo
JP Morgan Chase
• Bear Stearns and Lehman Brothers – likely would have been included
had they been independent going concerns in October 2008
• Mellon Financial and Countrywide – acquired by Bank of New York
and Bank of America just prior to the crisis
• AIG, American International Group
Data: Sources
• Insider trading data from Form 4 filings
– Obtained from Thomson Insiders’ database and actual
filings on SEC website
• Insider and director ownership from proxy statements
– Obtained from RiskMetrics and from actual filings on SEC
website
• Insider compensation data from 10-K and proxy
statements
– Obtained from Compustat Execucomp and from actual
filings on SEC website
• Financial and stock price data from Compustat & CRSP
Data: Key Variables
(1)
Value of Stock Sales
– Value of Stock Buys
– Value of Option Exercises
= Value of Net Trades
Value of Net Trades
+ Value of Salary & Bonus Compensation
– Unrealized Capital Loss from Drop in Share Price in 2008
.
(2)
=
Value of Net CEO Payoff
Data: Trade Information
Trades by all CEOs, 2000-2008 (Table 3A)
Total # of Sales
Total # of Buys
Total # of Option Exercises
2,048
73
470
+ Value of Sales
– Value of Buys
– Value of Option Exercises
$3,467,411,569
$ 36,400,641
$1,659,607,191
Value of Net Trades
$1,771,403,737
 $1.77 billion of cash taken off the table by bank executives
(High of $428m at Lehman Brothers; Low of -$7m at AIG)
Data: Trade Information
Total CEO Payoff by all CEOs, 2000-2008 (Table 4A)
+ Value of Net Trades
+ Total Cash Compensation
+ Realized Cash Payoffs to CEO
$1,771,403,737
$ 891,237,300
$2,662,641,037
– Unrealized Paper Loss, 2008
– $2,013,683,157
Net CEO Payoff, 2000-2008:
$648,957,880
(High of $377m at Countrywide
Low of -$311m at Lehman , but Dick Fuld at
Lehman realized cash of almost $500m)
Stock Returns: 2000-2008
350%
300%
Thru
2006:
+308.1%
Cumulative Portfolio
Returns: 2000-2008
(Equal Weight Portfolios)
250%
Thru
2006:
+198.9%
200%
Thru
2006:
+147.8%
150%
Thru
2008:
+46.6%
100%
Thru
2008:
+43.4%
Thru
2008:
-24.8%
50%
0%
NO-TARP
L-TARP
TBTF
Oct-08
Jul-08
Apr-08
Jan-08
Oct-07
Jul-07
Apr-07
Jan-07
Oct-06
Jul-06
Apr-06
Jan-06
Oct-05
Jul-05
Apr-05
Jan-05
Oct-04
Jul-04
Apr-04
Jan-04
Oct-03
Jul-03
Apr-03
Jan-03
Oct-02
Jul-02
Apr-02
Jan-02
Oct-01
Jul-01
Apr-01
Jan-01
Oct-00
Jul-00
Apr-00
Jan-00
-50%
Risk factors, Z-scores and Write-downs
ZScore
TBTF Firms (n=14)
# Total Amount ($M)
25th Percentile
Median
75th Percentile
L-TARP Firms (n=49)
# Total Amount ($M)
25th Percentile
Median
75th Percentile
No-TARP Firms (n=37)
# Total Amount ($M)
25th Percentile
Median
75th Percentile
8.919
19.756
24.446
10.862
20.972
39.146
8.506
21.994
51.420
vs. No-TARP
sample
Writedown
($M)
Writedown-toAssets
vs. NoTARP
sample
*
***
$293,035.0
$6,039.0
$19,872.0
$33,100.0
1.748%
3.264%
5.133%
***
***
***
$158,777.4
$158.9
$410.2
$1,143.0
1.992%
3.425%
6.334%
***
***
***
$64,016.2
$44.1
$81.2
$794.1
0.473%
1.444%
2.608%
**
***
CEO Trading and CEO Holdings
Total Net Trades: 2000-2008
Ratio of Trades to Beginning
Holdings:
2000-2008
TBTF Firms (n=14)
Median
$66,842,520
59.7% ***
$1,090,134
17.6% *
$1,226,977
4.0%
L-TARP Firms (n=49)
Median
No-TARP Firms (n=37)
Median
CEO Trading and CEO Holdings
Company
Total Cash
Value of Stock
Ratio of Trades to
Total
Net
Trades:
Compensation:
Holdings:
Beginning
2000-2008
2000-2008
Beginning of
Holdings: 2000(A)
(B)
2008
2000
TBTF Firms (n=14)
Mean Values
$494,177,483
$126,528,838
$63,659,807
103.4% ***
Median Values
$166,266,190
$66,842,520
$65,645,943
59.7% ***
Mean Values
$87,779,822
$2,666,599
$20,149,052
3.3%
Median Values
$64,473,910
$25,713
$13,072,593
0.0%
No-TARP Top 5 Holdings (n=5)
Summary of Results
• Bank executives at these 14 institutions took billions of dollars
‘off-the-table’ from 2000-2008, yet their shareholders lost
considerable amounts of money
– Consistent with Bebchuk, Cohen and Spamann (2010)
– Consistent with the Managerial Incentives Hypothesis
• Yes, the CEOs did lose considerable sums in the crash of 2008
• But, the 2008 paper losses much less than the cash already
realized during and prior to 2008
– Inconsistent with Fahlenbrach and Stulz (2009)
– Inconsistent with the Unforeseen Risk Hyposthesis
• Bank executive compensation was not aligned with the
returns shareholders received during 2000-2008, or with the
risks the firms took
Restricted Equity Proposal
• Proposal to reform executive compensation
• Annual cash compensation: $2 million limit
• Executive incentive compensation plans should consist
only of:
– Restricted stock
– Restricted stock options
– This compensation would be “restricted” in the sense
that the shares cannot be sold and the options cannot
be exercised for a period of 2 to 4 years after the
executive’s resignation or last day in office
Restricted Equity Proposal
• Proposal will provide superior incentives compared to
unrestricted stock and options plans for executives to:
1. Manage corporations in investors’ longer-term interest;
2. Diminish their incentives to attempt to achieve shortterm stock price appreciation by:
• Making aggressive public statements about
performance or investments
• Manage earnings
• Accept undue levels of risk
Caveats - 1
• Under-diversification: If executives are required to hold
restricted shares and options they would most likely be
under-diversified
• Problem: This lowers the risk-adjusted expected return for
the executive
• Solution: Grant additional restricted stock and restricted
stock options to the executive
– Would require some prohibition against engaging in creative
derivative transactions (such as equity swaps) or borrowing
arrangements that would hedge the payoff from the restricted
shares/options
Caveats - 2
• Lack of Liquidity of executives’ compensation
• Problem: Given that the average tenure of these CEOs is
about 5 years, a CEO may have to wait 7-9 years before
being allowed to sell shares/options and realize their
incentive compensation
• Solution: Allow sale or exercise of some portion of the
executive’s portfolio, possibly 5-15% of their shares/options
– But, for some CEOs, this could be $100+ million in sales
– Limit the annual ownership position liquidations to a dollar amount
of $5-$10 million
Liquidity: TBTF and No-TARP CEOs
Company
Total Cash
Value of Stock
Ratio of Trades to
Total
Net
Trades:
Compensation:
Holdings:
Beginning
2000-2008
2000-2008
Beginning of
Holdings: 2000(A)
(B)
2008
2000
TBTF Firms (n=14)
Mean Values
$494,177,483
$126,528,838
$63,659,807
103.4% ***
Median Values
$166,266,190
$66,842,520
$65,645,943
59.7% ***
Mean Values
$87,779,822
$2,666,599
$20,149,052
3.3%
Median Values
$64,473,910
$25,713
$13,072,593
0.0%
No-TARP Top 5 Holdings (n=5)
2 Key Points
• We are not advocating more compensation-related regulation
– Boards of directors, not regulators, should determine:
1.The mix and amount of restricted stock and restricted stock
options a manager is awarded
2.The percentage and dollar amount of holdings a manager can
liquidate each year, prior to retirement
3.The number of years post-retirement/resignation required for
the stock and options to vest.
• This need not reduce executive compensation
– The net present value of all salary and stock compensation can
be higher than historical levels, so long as the managers invest
in projects that lead to long-term value creation
– This proposal limits annual cash amounts, not total amounts
Caveats - 3
• Recommendations based on equity-based
incentives for executives
• High current levels of debt (~95%) will magnify
losses
• As a bank’s equity value approaches $0 – as they
did for some banks in 2008 – equity based
incentive programs lose their effectiveness in
motivating managers to maximize shareholder
value
Caveats - 3
• Problem:
With high levels of debt, equity
incentive programs lose their effectiveness
Banks should use
significantly more equity capital
• Solution:
– Large banks have 95-97% of capital from debt (3%-5%
equity)
– For the corporate sector as a whole, the debt ratio is about
47% (53% equity)
– Banks need to adjust their equity levels to become more like
the corporate sector as a whole
for equity incentive programs to be effective in bad economic times
Large Bank Capital Requirement Recommendations
Large Bank
Equity
Capital in
October
2008
3% to 5%
Basel III
International
Recommenda
tion (June 25,
2011)
8% to 9.5%
by 2019
Federal
Reserve
Bank
Governor
Daniel
Tarullo
(WSJ, June
16, 2011)
14%
Wall Street
Journal
Op-ed
October 24,
2011
Bhagat
and
Bolton
(July
2010)
Admati,
Demarzo,
Hellwig and
Pfleiderer
(September
2010)
“That
means
higher, even
very high,
bank capital
standards…
”
“Several
times
current
equity
capital
ratios”
“Significantly
higher equity
requirements”
25%
20% to 30%
U.S.
Corporate
Sector
53%
Fallacy of the argument
“Increased equity requirements will increase banks’
funding costs”
Corporation’s Funding Cost = Debt Ratio * Cost of Debt
+ Equity Ratio * Cost of Equity
Fallacy of the argument
“Increased equity requirements will lower the
Return on Equity (ROE)”
ROA = Debt Ratio * After-tax Return on Debt
+
Equity Ratio * ROE
The Regulated Hybrid (Contingent Capital) Proposal
Current Situation
The Regulatory Hybrid Security Proposal
Equity
The Restricted-Equity-More-Equity-Capital Proposal
Equity
Equity
Regulated Hybrid
Security
Bank Assets
Debt
Bank Assets
Bank Assets
Debt
Debt
Conclusions
• Compensation received by CEOs during 2000-2008 at
14 large financial institutions shows that their incentives
were not properly aligned with long-term shareholders.
– They had incentives to undertake high-risk but valuedestroying investments at the expense of long-term
value creation.
• Incentive compensation plans should use only restricted
stock and restricted options that cannot be converted to
cash for 2-4 years after the CEO leaves the firm.
• Banks should use significantly more equity capital
(equity: about 25%).