Did executive pay help cause the crisis?

By Felix Salmon
December 8, 2009
Lucian Bebchuk, Alma Cohen, and Holger Spamann explain how executive pay at investment banks helped precipitate the crisis:


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Lucian Bebchuk, Alma Cohen, and Holger Spamann explain how executive pay at investment banks helped precipitate the crisis:

Our analysis undermines the claims that executives’ losses on shares during the collapses establish that they did not have incentives to take excessive risks. The fact that the executives did not sell all the shares they could prior to the meltdown does indicate that they did not anticipate collapse in the near future. But repeatedly cashing in large amounts of performance-based compensation based on short-term results did provide perverse incentives – incentives to improve short-term results even at the cost of an excessive rise in the risk of large losses at some (uncertain) point in the future.

Jeffrey Friedman, and those like Tyler Cowen who agree with him, are still welcome to believe that pay wasn’t a factor in the crisis. But I think they have to admit at this point that there is a coherent argument to push back against, rather than simply asserting, as Friedman does, that there’s no argument there at all. (Of course no one is saying that executive pay was the biggest factor. But I think there’s a colorable case that it played an important-if-not-decisive role.)

8 comments

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Every post has “Continue reading…” even though often you _are_ done. Problem is (and I’d never noticed this before) you leave many of your posts on a not-obviously-conclusive note. Many sites can expand such a “more” link quasi- instantaneously but since the new reuters is so early-90′s slow (on platforms where it loads at all rather than just hanging forever) this is a nuisance.
Felix, is there any chance you could end each entry with something very obvious (e.g. “END.”) to help us readers avoid this particular breakage.

N.b. comment previews remain a good idea.
N.b.2. No, not everyone reads you with internet explorer on windows. Maybe most do, but if that’s fine with Reuters it would be more honorable to just post a banner up front telling everyone else to just go away.

Posted by axg3 | Report as abusive

axg3, I can assure you that things aren’t any better in IE/Windows. I think maybe the ENDS workaround might be the way to go for the time being…

Try on the complete fraud to the creation of the mortgage backed securities and bogus CDS’s sold by A.I.G… All when is was completely reliant upon real estate values never even plateauing, my industry ought to have known better than to offer a 2-year ARM, with huge first adjustments up to 106% (yes 106%) financing to a person with feces for credit and no skin in the game…

HOWEVER, it could never have occurred without the “Bear Stearns” of Wall Street enticing the “Fitch’s, S&P’s and Moody’s of the world” with ludicrous profits into equally fraudulent ratings AND getting A.I.G. to offer an insurance instrument that it had no hope or way of paying off on…

The commissions and bonus’s were based on sales of, albeit bogus, instruments and thus “earned”…

Posted by GotDOCG | Report as abusive

Did executive compensation cause the Internet bubble to crash?

Everyone was paid by stock options back then and the dumbest programmers were multi-millionaires on paper. Because the executives for Internet firms made so much money, I hereby declare executive compensation played an important-if-not-decisive role. Just because much of their wealth was destroyed during the bursting of the bubble does not mean executive compensation was not a major part of the bursting of Internet bubble.

Alternative arguments for both bubbles exploding specularly is that the free market recognized the lack of basis for both business models and pull support. Too many people were in it for the easy money (individual and corporate investments, retirement plans) and we all were affected by it.

People and companies who lived within their means were affected least by this downturn. Even if you lost your job as a result, lack of debt and high savings allows you to weather the recession and not lose everything. If your standard of living is contingent on continuous employment with little or no margin for error, then you’re living way above your means.

Stop blaming everyone else.

Posted by TElton | Report as abusive

Good grief T Elton. In what world do you live? The vast majority of the population lives from month to month. No job and they are pretty much kaput. Over one third of los angeles county is now making less than needed to meet the basic necessities of living. Wake up and smell the ether.

Posted by Uncle_Billy | Report as abusive

What is your premise Uncle_Billy? T Elton is correct. You repeated the premise yourself: With no savings and no job, these people are “kaput”. Nobody says that saving money and living within your means is easy. Perhaps this is vastly more difficult now with the “one third of Los Angeles County” unable “to meet the basic necessities of living” today. But your comment still underlines the point. I feel for Los Angeles County – heck, everybody does. Our feelings will not solve the problem. Living within means and disciplined saving will. This is not insurmountable.

Posted by jdhahn | Report as abusive

I just rewatched “It’s a Wonderful Life”, which, among other things, is a movie about the value of banking. It reminded me that, until fairly recently, banking was considered a boring profession. Some bankers got rich, but many didn’t. It was respectible, important, but never exciting. “Staid” was a word that could have been invented for bankers. George Bailey had dreamed of an exciting life seeing the world and constructing great buildings; he settled for life as a banker. It took a miracle to convince him that he had “a wonderful life”.

Today, banking is considered exciting. Bankers think of themselves as creative, inventing new ways of making money. Bankers have vision, they take risks, they are adventurous. So, they deserve to be rewarded when they succeed. Their managers expect them to make big profits, and tell them so.

This is a mistake. Banking should be boring. Bankers should worry about safety, about slowly and steadily increasing value. They should focus on following the rules, on being efficient, on being safe. The current problem was caused by bankers taking risks. Sometimes taking risks pays off. Sometimes it doesn’t. But when banks that are “too big to fail’ get in trouble, someone else has to pay for it.

There is a place for risk taking in finance, but banks are not it. People who want to take risks should form hedge funds or become venture capitalists. Banks should ensure the orderly flow of money. The entire economy depends on banks, so it is reasonable for the government to gaurentee and to inspect them.

How to make this happen? How can we return to an image of banking as safe and boring? I’m no expert, but I bet if you put a cap on compensation, you’d convince a lot of risk-takers to leave banking. That would be a good thing.

Posted by RalphJohnson | Report as abusive

Uncle_Billy

” The vast majority of the population lives from month to month” because there is little concept of savings.

There is no concept of saying no to a $299/month car lease payment when a $3,000 used car (or bus) will do, and not everyone in the family need cell phones with a text/3G video data plan. Since when did $119/month cable TV become a must-have utility for 90% of households?

Everyone can save $500/month if they can say no to just these three things above. Instead, they’re contractually locked into two to three year commitments and complain they can’t save money.

Uncle_Billy – looks like you do live in a different world from some of us.

Posted by TElton | Report as abusive