Executive compensation as a cause of the crash? The evidence

Posted by Marc Hodak on August 8, 2009 under Collectivist instinct, Executive compensation | Read the First Comment

It has been a mantra of corporate critics, and a major source of the justification for extensive pay regulations, that executive compensation was a contributing factor in the financial crisis.  In particular, we keep hearing three assertions underlying ever growing pay regulations:

– Lack of alignment of top executives and their shareholders contributed, if not precipitated, the financial crisis

– Stock options, in particular, provided an asymmetrical risk/reward structure for executives that induced greater risk-taking

– Senior executives were able to successfully insulate themselves from the losses they created for their shareholders.

So, I often find myself asking, how do these three assertions apply to, say, the poster children of the financial meltdown Jimmy Cayne or Dick Fuld?  Is it conceivable that they would have put up their personal fortunes on the bets made by their firms if they had really understood them?  Fuld and Cayne could be accused of a lot of things–arrogance, short-sightedness, poor leadership–but they cannot be called stupid, and they certainly couldn’t be called disinterested or poorly aligned with their shareholders.

Now Rudiger Fahlenbrach and Rene Stulz have gone beyond the anecdotal experience of these two CEOs to broadly study the impact of CEO and shareholder alignment upon bank performance through the financial crisis.  Here is what they concluded:

There is no evidence that banks with CEOs whose incentives were better aligned with the interests of their shareholders performed better during the crisis and some evidence that these banks actually performed worse both in terms of stock returns and in terms of accounting return on equity.  Further, options compensation did not have an adverse impact on bank performance during the crisis.  Bank CEOs did not reduce their holdings of shares in anticipation of the crisis or during the crisis; further, there is no evidence that they hedged their equity exposure.

That takes care of not one or two, but all three assertions.  I’m sure the regulators didn’t want to base anything on the anecdotal evidence of actual CEOs and firms when alternative hypotheses and conclusions were available.  Now that empirical evidence is available (which, based on our own preliminary research, I’m all but certain will not be refuted), I’m looking forward to seeing how it is incorporated into the deliberations on regulatory reform.