Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation. This blog is currently suspended.

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Fri, 12 Jun 2009

Bankers’ pay and incentives

Much has been written about how (a) bankers’ pay is excessive and (b) the incentive created by these pay structures encourage risk taking. A lot of this discussion has treated bankers’ pay as a corporate governance problem without considering the special characteristics of banks. I was therefore delighted to read this paper by Bebchuk and Spamann which is like a breath of fresh air.

Bebchuk and Spamann point out that because of the excessive leverage of banks and the explicit and implicit support of the government, the shareholders are incentivized to support excessive risk taking. Therefore the standard corporate governance ideas of aligning the interests of managers with that of shareholders are useless when it comes to banking. They propose that regulators should step in and require that incentives be linked to the total value of the firm and not just the value of the equity.

Bebchuk and Spamann do not address the issue of bankers’ pay being excessive though that has a similar explanation. Deposit insurance and implicit government guarantees create the potential for huge rents in banking. The only way to extract these rents is by highly complex (and possibly deceptive) risk taking strategies that get past regulatory restrictions. Implementing these strategies therefore requires a great deal of expertise and skill which are in short supply. Therefore when shareholders try to extract rents by hiring smart people to implement complex risk taking strategies, most of the rents are in fact extracted by the managers themselves. To view this as a corporate governance problem is a mistake. It is a problem of government policy that encourages rent seeking.

Bebchuk and Spamann also correctly point out that the managers whose personal wealth has been destroyed by the collapse of their banks were not necessarily stupid or ex ante irrational. Ex ante, they could well have been responding correctly to the incentives that they faced and the probabilities that they estimated.

Posted at 16:11 on Fri, 12 Jun 2009     View/Post Comments (2)     permanent link