In the fallout from the financial crisis of 2007-8, a number of official policy documents have reported on its causes and have identified executive pay packets and bonuses in banks and financial institutions as being partly to blame.
In the UK, chairman of the Financial Services Authority (FSA) Adair Turner claimed that “inappropriate incentive structures played a role in encouraging behaviour which contributed to the financial crisis” (Turner 2009 p79), while the US Financial Crisis Inquiry Commission said that “Lehman’s failure resulted in part from significant problems in its corporate governance, . . . exacerbated by compensation to its executives . . . that was based predominantly on short-term profits” (FCIC 2011 p343)1.
- In the US, the recent Dodd-Frank Wall Street Reform and Consumer Protection Act mainly focused on reforms to the regulation of financial institutions, but also introduced corporate governance provisions, including required shareholder approval for executive compensation packages (“say-on-pay”).
- In the UK, there are proposals to split the FSA into two separate organisations: the Financial Conduct Authority and the Prudential Regulatory Authority (which will be a subsidiary of the Bank of England); and the Vickers Report (2011) proposes to ring-fence retail banking from investment banking.
- The FSA introduced a Remuneration Code from January 2010, updated in January 2011 to be consistent with the EU’s Capital Requirements Directive (CRD3/CEBS).2 The principles of the Code are that firms should align remuneration structures with sound risk management practices, incentive payments should be deferred over a number of years with claw-back provisions, and performance criteria should be related to long-term profitability.
But, taking a step back, what is the evidence that incentive misalignment was responsible for the crisis in the first place?
New research on banker pay
In recent research (Gregg et al. 2011), my colleagues and I investigate whether bank executives had been incentivised to take undue risks. To do this, we examine the pay-performance relationship of executives in all UK companies, and in financial services companies in particular. We argue that, if an emphasis on short-term profits in the banking sector meant that remuneration structures in banks and financial services were to blame for the crisis, then there should be evidence that in the run-up to the crisis pay-performance sensitivities were higher in the financial services sector than in other sectors.
We report that base pay compensation and bonuses of all UK executives in FTSE350 companies increased substantially over the period 1994-2006, and that pay in the financial services sector is particularly high. Pay of the highest paid director (typically the CEO) increased by 131.78% and total board pay increased by 80.41% over the period 1997-2006, compared with a 41.38% increase for all employees. Table 1 shows how the average real pay of the highest paid director and total board varies by industry, with the financial services sector ranking second under both measures behind the non-cyclical services sector, which includes food and drug retailers and telecommunications.
Table 1. Mean total board pay and pay of highest paid director by industry at 2006 prices
||Industry group||Total board pay (£’000)
Highest paid director (£’000)
|4||Cyclical Consumer Goods||2,567.39||5||792.16||5|
|5||Non-cyclical Con. Goods||2,787.18||4||805.41||4|
|9||Financials (including banks)||3,544.80||2||915.88||2|
Source: Gregg et al. (2011)
Yet, contrary to the prediction that pay was over-sensitive to short-term performance, we find that the pay-performance sensitivity of banks is not significantly higher than in other sectors, and in general is actually quite low. Across all industries, we find a weak relationship between executive pay and company performance. The estimates suggest that a 10% additional increase in company share price performance leads to a 0.68% increase in the pay of the CEO, which translates into a £3,726 increase in CEO pay at the median level of £543,200.
We report that although the pay-performance relationship is slightly higher in the financial services sector for both total board pay and pay of the highest paid director, the additional sensitivity is not statistically significant, and is still economically very small. This tiny performance-related element of executive pay means that there is little evidence that executive compensation in the banking sector depended on short-term financial performance. In other words, executives were paid irrespective of performance. In which case, it seems unlikely that bankers were incentivised to take risks, and refutes the suggestion that incentive structures in banks could be blamed for the crisis3.
We also report that firm size has a larger effect on executive pay than firm return. A 10% increase in firm size measured by total assets, increases CEO pay by 2%, and this translates into a £11,815 increase in CEO pay at the median level. This implies, somewhat against the prevailing wisdom, that executive pay is more sensitive to firm size than firm performance.
It has been argued that remuneration packages in the financial services sector may have been partly responsible for the global financial crisis. It would appear, however, that the mechanism for such an impact is not through the relationship between executive pay and stock market performance, but instead through the incentive for executives to ensure that their firm’s assets are as large as possible.
The reforms to executive remuneration in financial services through the adoption of a ‘Remuneration Code’ may be accused of jumping the gun, since it is not clear that bonus payments over-incentivised executives in the first place. However there are two reasons why such regulations are appropriate.
- First, the requirement that bonus payments be fully transparent, partially deferred and performance-adjusted, ensure that executive bonuses are related to long-term corporate performance, and seem reasonable conditions for any performance-related ‘variable compensation’ scheme.
- Second, there have been a series of corporate governance reports in the UK over the last 20 years (Cadbury 1992, Greenbury 1995, Hampel 1998, Turnbull 1999, and Higgs 2003), yet these reports and recommended policies have failed to stem the dramatic increase in executive pay.
In September 2011, the UK government’s Department for Business, Innovation and Skills issued a discussion paper on structures for executive remuneration. If this latest report is to have any effect, it is important that regulations stay one step ahead of the regulated.
Beltratti,A and RM Stulz (2010), “The Credit Crisis Around the Globe: Why Did Some Banks Perform Better?”, Dice Center Working Paper No. 2010-05, Fisher College of Business.
Cadbury, A (1992), Report of the Committee on the Financial Aspects of Corporate Governance, Gee & Co.
Committee of European Banking Supervisors (2010), “Consultation Paper on Guidelines on Remuneration Policies and Practices”, Consultation Paper No. CP42.
Conyon, MJ, N Fernandes, MA Ferreira, P Matos, and KJ Murphy (2010), “The Executive Compensation Controversy: A Transatlantic Analysis”, redraft of Annual FRDB conference paper.
Department for Business Innovation and Skills (2011), Executive Remuneration: Discussion Paper, September.
European Commission (2009), Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL amending Directives 2006/48/EC and 2006/49/EC as regards capital requirements for the trading book and for re-securitisations, and the supervisory review of remuneration policies, July.
Erkens, D, M Hung, and P Matos (2009), “Corporate Governance in the 2007-2008 Financial Crisis: Evidence from Financial Institutions Worldwide”, University of Southern California Working Paper, August 2009.
Fahlenbrach, R, and RM Stulz (2011), “Bank CEO Incentives and the Credit Crisis”, Journal of Financial Economics, 99, 11-26.
Financial Crisis Inquiry Commission (FCIC) (2011), Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the US, (US Government Printing Office; Washington), 545 pages.
Financial Services Authority (2009), Reforming remuneration practices in financial services, Consultation Paper, 09/10 March.
Greenbury, R (1995), Directors Remuneration: Report of a Study Group Chaired by Sir Richard Greenbury.
Gregg, P, S Jewell, and I Tonks (2011), "Executive Pay and Performance: Did Bankers' Bonuses Cause the Crisis?", International Review of Finance DOI: 10.1111/j.1468-2443.2011.01136.x
Hampel, R (1998), Committee on Corporate Governance: Final Report, Gee Publishing.
Higgs, D (2003), Review of the role and effectiveness of non-executive directors, Department of Trade and Industry.
Turnbull, N (1999), Internal Control: Guidance for Directors on the Combined Code, London Stock Exchange.
Turner, A (2009), A regulatory response to the global banking crisis, March, Financial Services Authority.
US Senate (2011), Wall Street and the Financial Crisis: Anatomy of a Financial Collapse. Majority and Minority Staff Report, Permanent Subcommittee on Investigations, Washington, 646 pages.
Vickers, J (2011), Independent Commission on Banking: Final Report Recommendations, September.
Walker, D (2009), A review of corporate governance in UK banks and other financial industry entities: final recommendations, Financial Services Authority, November.
1 See also Walker 2009 and FSA 2009 for the UK and US Senate 2011 for the US.
2 With respect to executive remuneration, Walker (2009) and FSA (2009) identified potential market failures in the structures of remuneration practices in financial services, and suggested that an emphasis on short-term profits by institutional investors had encouraged executive remuneration to be focused on “variable compensation” (bonuses) related to the most recent earnings, without any consideration of the exposure to risk-taking.
3 A number of other papers have also examined the evidence as to whether mis-aligned incentives were the cause of the financial crisis. Fahlenbrach and Stulz (2011) argue any perverse incentives are dampened if the interests of executives and shareholders are aligned through executives’ ownership of company stock.
In a comparison of the US and Europe, Conyon et al. (2010) show that the role of compensation in promoting excessive risk taking prior to the crisis was dwarfed by the roles of loose monetary policy, social housing policies, and financial innovation. Beltratti and Stulz (2010) undertake a cross-country comparison of the performance of banks during the financial crisis, and find that it was the fragility of banks’ balance sheets, and in particular their reliance on short-term capital market funding, that explained their poor performance. On the other hand, Erkens, Hung and Matos (2009) examine corporate governance policies in 306 financial institutions across 31 countries during the credit crisis. In contrast to the evidence for US banks, they find that financial firms that used CEO compensation contracts with a heavier emphasis on non-equity incentives (bonuses) rather than equity-based compensation) performed worse during the crisis and took more risk before the crisis.