Compensation packages for senior executives, particularly, Chief Executive Officers (CEOs) is important because it enables firms to attract and retain the best available in the labor market and the type of pay contracts helps to determine whether they will focus on maximising firm value. Economists have identified at least three ways in which firms can use their flexibility in setting the level and sequencing of pay to enhance employee motivation, these methods include the payment of efficiency wages, upward-sloping earning profiles and the tying of major pay increases to promotions (Brickley, Smith & Zimmerman, 2007).
During the decade spanning 1999 and 2000, CEO compensation increased by an average of 1300% and in 2004 the average pay received by CEOs of major companies was $9.84 million (as cited in Kellis 2004). In 2007, the average total compensation received by 6 top executives of Bank of America was $12.2million and $64.38million for 5 top executives of Goldman Sachs (company proxy statement for 2007). Many considered this pay level as high, and argued that the World Financial Crisis of 2008-2009 was as a result of inappropriate compensation policies and excessive risk-taking in financial institutions. And there have been various initiatives by government of different countries to regulate bank executive pay following the bailouts in the aftermath of the financial crisis.
Some writers argue that the government representing the economic interest of taxpayer should regulate the compensation of bank executive, considering the link between the risks financial institutions take and the costs they impose on taxpayers, which gives the society a stake in the structure of executive compensation in financial firms. Other writers disagreed; according to Greenberg, et al. (2010) governments should generally not regulate the level of executive compensation in financial institutions. In their study, no convincing evidence has been seen that high levels of compensation in financial companies are inherently risky for the companies themselves or the overall economy. Moreover, limits on pay are likely to cause unintended consequences. As a result, society is better off if compensation levels are set by market forces. Core, Guay and Thomas (2005) and Kaplan (2008) examined several of the frequent complaints about executive compensation, and argue that many of these concerns are either incorrect or overstated. They pointed out that market forces heavily influence executive compensation. Some others believe that there should be a balance of free market and regulation in an attempt to relate compensation to executive performance (Kellis, 2004)
This essay briefly discuss the different views: those in support of government regulating bank executive compensation and those against it and related consequences.
Although the majority of economists believe that government should not be involved in the determination of executive pay, there exists a minority of economists, both neoclassical and social democratic, who claim that government regulation of executive pay will result in efficient market conditions. In their view, the most efficient market conditions will be achieved through government regulation of executive compensation (Kellis 2004). Advocate of regulation of bank executive pay believe that regulations will limit executives from making business decisions that would serve their interests but produce excessive risks and impose an externality.
In the research work of Paracon (2003), many respondents claimed that executive pay is excessive and out of control, they believe that government intervention would increase investor confidence. According to Bebchuk and Spamann (2009), regulating banks is not a new phenomenon, ‘interference in business decisions is already commonplace' and is viewed as justified by the fundamental moral hazard problems. They strongly believe that even if executive pay arrangements were perfectly aligned with common shareholder interests, there would still be a strong basis for monitoring and regulating executive pay in banks. Combining traditional direct regulation of banks' actions and activities with regulation of bank executives' pay structures they say may well improve the overall effectiveness of banking regulation. It would thus contribute to securing the safety and soundness of the banking sector.
It is important that the compensation packages correspond with the executives' performance in order to provide incentives for them to work harder (Abowd and Kaplan, 1999). Regulating the level of compensation for financial executives could do more harm than good, both to the firms being regulated and to the overall economy; it could cause a slow growth in economy-wide output and average standards of living (Greenberg, et al. 2010). Besides, it is not at all clear that compensation is the right suspect to be held responsible for the credit crunch. Although the level of executive pay may be high, Greenberg, et al. (2010) argued that they are not convinced that these high levels of compensation are inherently destabilizing to individual firms or to the overall financial system. They further argued that proposed regulations may make corporations more productive, but they also may create significant costs and unintended consequences such as to push most talented bankers to unregulated firms or even drive parts of this highly mobile industry to more receptive countries. Bankers were not always this well-paid, after all, but financial crises still occurred (Economist, May 2008). Although it is right for regulators to be concerned about risk-taking incentives of executives, there is the need to recognise that some risk-taking is necessary to compete effectively within any industry argued Core & Guay (2010).
In addition to negatively affecting high performers and making mediocrity the new executive norm, regulation would also make compensation politically rather than performance driven, and therefore decrease the efficiency of the market (Kellis 2004). Besides, the introduction of compensation committees in the UK and Europe witnessed executive pay rising even more rapidly than before, as rewards were legitimised through being subject to due process (Kirchmaier 2008). It is almost impossible to devise tight rules for every action and product in a bank and even if this is possible, such regulation would be highly undesirable as it would stifle innovation and destroy the advantages of decentralised organisation. Investors are concerned about losing talented executives (Kim, 2010); ‘Changes that reduce the conflict between management and shareholders can magnify the conflict between financial institutions and society' (Greenberg, et al. 2010).
In view of the discussions above, it is not in doubt that compensation for CEOs is important as it provides motivation for them to put in the best effort at maximising returns to shareholders and regulating compensation may undermine this vital factor. However, inappropriate compensation structure may incentivise CEO to excessive risk-taking which may jeopardise shareholders interest. Optimizing these two positions may well be the required recipe that will enable a complimentary interaction and a positive outcome. Regulators, rather than exert more direct controls through pay regulation, can provide reform policy frameworks and recommend structures that discourage strong incentives to take excessive risks while leaving the implementation at the discretion of banks. Executives should also adopt corporate governance best practices that will ensure compensation are more in line with regulators expectation and recognize the strategic importance of banks to the overall safety and soundness of the financial system and the economy as a whole.
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