In Alan Greenspan’s famous admission of error, it was the failure of “the self-interest of lending institutions to protect shareholders’ equity” that left him in “a state of shocked disbelief”.
A pity that the growing body of literature explaining the failure of bank shareholders themselves wasn’t around then, or he might have framed things differently. He also might have been less shocked.
These academic studies, ably summarized by the Harvard Business Review, conclude not that bank executives took excessive risks because their incentives were misaligned with those of shareholders, but precisely because their incentives were aligned so well. In other words, shareholders encouraged the irresponsible risk-taking.
Why would they? Here’s how HBR’s Justin Fox explains the preliminary work of Columbia’s Patrick Bolton, the New York Fed’s Hamid Mehran, Oxford’s Joel Shapiro:
The gist of their argument is that equity in a highly leveraged firm (banks and investment banks have debt-to-equity ratios that start at 10-to-1 and go much higher) is equivalent to a call option. That is, if the firm goes bust the equity holders only lose a little but if it does well they can reap huge rewards. So shareholders have every incentive to push executives at highly leveraged firms to take big risks (and executives with big equity stakes have every incentive to take big risks).
And now there’s a new submission from Simon Wong of Northwestern focusing on institutional investors across a variety of countries, and why they’ve been such poor stewards of the companies they own. The five reasons:
—inappropriate performance metrics and financial arrangements that promote trading and short-term returns
—excessive portfolio diversification that makes monitoring difficult
—lengthening share ownership chain that weakens an ‘owner’ mindset
—misguided interpretation of fiduciary duty that accords excessive deference to quantifiable data at the expense of qualitative factors
—flawed business model and governance approach of passive funds
The problems themselves are neither new, nor complicated, nor all that surprising, really — all of which is different from saying they are easy to solve. The paper focuses on institutional investors in all kinds of companies, but there’s no reason to think that any of the above wouldn’t also apply to banks.
If these studies are right, the problem isn’t that shareholders lacked sufficient power to look after their companies, but that they simply aren’t up to the job. Better, then, to also include other stakeholders when considering how to incentivize management.
This was Lucian Bebchuk’s idea in a recent column for Syndicate, aptly titled “How to pay a banker” (and is also floated in the Bolton paper). Bebchuck wants the Fed, in its newly expanded supervisory role, to design what he thinks would be a more sensible compensation structure for the banks (emphasis ours):
To the extent that executive compensation is tied to the value of specified securities, such pay could be tied to a broader basket of securities, not only common shares.
Thus, rather than tying executive pay to a specified percentage of the value of the bank’s common shares, compensation could be tied to a specified percentage of the aggregate value of the bank’s common shares, preferred shares, and all the outstanding bonds issued by the bank. Because such a compensation structure would expose executives to a broader share of the negative consequences of risks taken, it would reduce their incentives to take excessive risks.
But even this doesn’t go far enough, he argues, as it wouldn’t take into account the government’s role as a guarantor of deposits. And Bebchuk has an idea for this too:
To do so, executive payoffs could be made dependent on changes in the value of the banks’ credit-default swaps, which reflect the probability that the bank will not have sufficient capital to meet its full obligations.
Given the role of credit default swaps in the crisis, and how frequently they are cited as an example of a dangerous Wall Street innovation, there’s a bit of poetry in this idea.
Related links:
How to pay a banker – Project Syndicate
Banks took big risks because shareholders wanted them to – Harvard Business Review