Bank Executive Compensation And

Capital Requirements Reform

Sanjai Bhagat Brian Bolton

University of Colorado University of New Hampshire

International Monetary Fund

Washington, DCMarch 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 #1Consider 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 #2Given 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

2008Bank of America Merrill LynchBank of New York Mellon Morgan

StanleyCitigroup State StreetGoldman Sachs Wells FargoJP 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

Value of Stock Sales – Value of Stock Buys – Value of Option Exercises

(1) = 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 2,048Total # of Buys 73Total # of Option Exercises 470+ Value of Sales$3,467,411,569– Value of Buys $ 36,400,641– Value of Option Exercises$1,659,607,191Value 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$1,771,403,737+ Total Cash Compensation $ 891,237,300+ Realized Cash Payoffs to CEO$2,662,641,037

– Unrealized Paper Loss, 2008 – $2,013,683,157

Net CEO Payoff, 2000-2008:$648,957,880

(High of $377m at CountrywideLow of -$311m at Lehman , but Dick Fuld at

Lehman realized cash of almost $500m)

Stock Returns: 2000-2008

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Cumulative Portfolio Returns: 2000-2008

(Equal Weight Portfolios)

NO-TARP L-TARP TBTF

Thru2008:

-24.8%

Thru2006:

+198.9%

Thru2008:

+46.6%

Thru2006:

+147.8%

Thru2006:

+308.1%

Thru2008:

+43.4%

Risk factors, Z-scores and Write-downs

Z-

Score vs. No-TARP

sample

Write-down ($M)

Write-down-to-

Assets

vs. No-TARP sample

TBTF Firms (n=14) # Total Amount ($M) - $293,035.0 - 25th Percentile 8.919 $6,039.0 1.748% *** Median 19.756 * $19,872.0 3.264% *** 75th Percentile 24.446 *** $33,100.0 5.133% *** L-TARP Firms (n=49) # Total Amount ($M) - $158,777.4 - 25th Percentile 10.862 ** $158.9 1.992% *** Median 20.972 $410.2 3.425% *** 75th Percentile 39.146 *** $1,143.0 6.334% *** No-TARP Firms (n=37) # Total Amount ($M) - $64,016.2 - 25th Percentile 8.506 $44.1 0.473% Median 21.994 $81.2 1.444% 75th Percentile 51.420 $794.1 2.608%

CEO Trading and CEO Holdings         

 

Total Net Trades: 2000-2008Ratio of Trades to Beginning

Holdings: 2000-2008 

 

       

 

TBTF Firms (n=14) 

 

 Median $66,842,520 59.7% ***

  

 

L-TARP Firms (n=49)

 Median $1,090,134 17.6% *

  

 

No-TARP Firms (n=37)

 Median $1,226,977 4.0%

         

CEO Trading and CEO Holdings

CompanyTotal Net Trades:

2000-2008

Total Cash Compensation:

2000-2008(A) (B)

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% ***

No-TARP Top 5 Holdings (n=5)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%

Value of Stock Holdings:

Beginning of 2000

Ratio of Trades to Beginning

Holdings: 2000-2008

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 short-term 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

CompanyTotal Net Trades:

2000-2008

Total Cash Compensation:

2000-2008(A) (B)

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% ***

No-TARP Top 5 Holdings (n=5)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%

Value of Stock Holdings:

Beginning of 2000

Ratio of Trades to Beginning

Holdings: 2000-2008

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 awarded2.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

• Solution: Banks should use significantly more equity capital– 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

Basel III International Recommendation (June 25, 2011)

Federal Reserve Bank Governor Daniel Tarullo (WSJ, June 16, 2011)

Wall Street Journal Op-ed October 24, 2011

Bhagat and Bolton (July 2010)

Admati, Demarzo, Hellwig and Pfleiderer (September 2010)

U.S. Corporate Sector

3% to 5%

8% to 9.5% by 2019

14%

“That means

higher, even very high,

bank capital standards…

”

“Several times

current equity capital ratios”

25%

“Significantly higher equity requirements”

20% to 30%

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 Restricted-Equity-More-Equity-Capital Proposal

Bank Assets

Equity

Debt

The Regulatory Hybrid Security Proposal

Bank Assets

Equity

Regulated Hybrid Security

Debt

Current Situation

Bank Assets

Equity

Debt

The Regulated Hybrid (Contingent Capital) Proposal

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 value-destroying 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%).