C o m p e n s a t i o n

a n d R e m u n e r a t i o n P o l i c i e s o f t h e B o a r d M e m b e r s a n d T o p E x e c u t i v e s
Institutions Of Financial Stability
Prof. Fernando Fernandez

Kunwar Aditya P. Singh

MIAF NOVEMBER 2012.

Introduction
This financial crisis has set the world in turn moil. Even though companies have taken huge losses but those losses have hardly reflected in the pay packets and bonuses of the executives. Companies increased their bonus pools and executives after executive walked away with higher bonuses even higher severance packages whilst the taxpayers money was used to bail their institutions; this specially has been the case in the financial institutions. All this has brought the issues of executive compensation back to forefront of the debate. Is it too much? Is it morally correct for some people to make so much money while some go out of jobs? Or is it rent taking mentality that is cause of the issue? Further, is it only the financial sector or other sectors have this supposedly inherently flawed compensation policies? But the question to start with is are top executives seriously overpaid?

Overpaid?

The above graph1 shows the rise in the median compensation of the CEO and other top executives since 1940 to 2000. The rise in compensation in 1990 was dramatic with annual growth rate reaching more than 10% by the end of the decade. This J shaped curve cannot be solely attributed to the market forces and competition; somewhere the 1 Carola Frydaman, Dirk Jenter CEO Compensation, Nov 2010. 2 http://www.law.northwestern.edu/colloquium/tax/documents/Walker-

compensation shot above the roof and that has to have a different explanation and perhaps executives are overpaid. This overpaid phenomenon is not only limited to the financial or just bailed out firms, but also to the real economy firms but certainly it has been more visible in financial firms.

Moral hazard?

High executive compensation also raises a question of moral hazard. Paying an executive hundred times more than the average employee is certainly not illegal, but it does poses a question of how much is enough? . Some argue that executives create more value than an average employee and therefore they need to be compensated and this compensation depends largely on the competition and market factors. This argument is specious at best. If there is a system that creates such a large disparity between sections of society then there is certainly something not correct with this kind of system and there has to be a governing principle either enforced or voluntarily imposed that would moderate the differential between the highest paid and the average paid employee. Further such a disparity can also be the cause a social unrest as we saw last year in London.

An agency problem or rent extraction or just plain scarcity?

Executive compensation is negotiated by the independent directors of the board who work on the line of the Optimal Contracting Model under which, 2a board of directors that cannot perfectly observe the effort, focus and effectiveness of its agent (CEO) negotiates a contract that minimizes the agency cost, which include 1) monitoring the executive, 2) bonding by executive to maximize the shareholders value and 3) the residual divergence between the actions selected by the executive and share value maximizing actions. This is called arm-length contracting. Whilst the assumption guiding this principle is the presumption that the executive attempt to get the best deal possible for itself and board gets the best deal possible for the shareholders. But, this relationship has broken down in some aspects and board does not always come up with the best agreement in favour of the shareholders. This gives rise to the rent extraction problem. Weak corporate governance, supplicant boards allow strong 2 http://www.law.northwestern.edu/colloquium/tax/documents/Walker- ExecutivePay.pdf

executives to set their own pay, which they try to maximize, leading to the inefficient compensation structure, unfavourable to the shareholders. But some do not agree with that and contend that the executive pay is just not the function of optimal contracting model or rent extraction, but most importantly a factor of competition and scarcity of good executives, especially for the large caps. It cannot be said that the executive compensation is factor of any one variable; Of- course there is an issue of rent extraction and that would be there as long as we follow the optimal contract model with its deficiencies, but scarcity also is a driver for the higher compensation. This scarcity theory is more visible is large companies where marginal competence of the executive can swing the fortunes of the business dramatically. But, scarcity theory does not hold much for small cap or a mid cap companies but it surely is an important factor, along with the rent extraction, in determining the compensation of the executives in large cap companies.

Models of compensation: How to pay?

There has been widespread debate about the linkages between the performance of the executive and the pay that they received. It is one of the areas that still lack clarity as compensation packages of the executive is linked to many observerable and unobservable factors. But in most basic form the compensation is linked with the stock price of the company either through direct stock options or through options and other camouflaged arrangements and higher value of stock price the better performance of the executive. This is both good and bad. It is good because it ties the compensation of the executive on an easily observable entity whose prices are determined mostly by the efficient market. Further, it helps to reduce the agency problem. But this induces two problems. First problem that emanates out of this arrangement is that the executives can manipulate the data and numbers to come up with better performance as it was evident in the case Enron, where executives used arcane accounting practices to hide the losses and in turn increased the so called profitability. Further, linking the performance to the share price where the executives hold a non-minor share promotes insider trading as well. Though there are strict laws in place to prevent this from happening, insider trading is not all banished from the corporate world.

Secondly and most importantly, fixing the compensation of the executive to the stock prices promotes excessive risk taking and decisions that in short term may produce higher stock price but actually detrimental the shareholders in the longer term. This behaviour was very evident in the financial market during the pre-crisis era where the big chunks compensation was mostly in form of the bonuses that in turn depended on the return on the equity, thus leverage. Thinly capitalised bank took on excessive risks whist highly leveraged, mostly at the ratio of 40 to 1, in order to produce the maximum alpha. This alpha came from taking excessive risk that entailed tail risk. So, in most of the time and in short run, this strategy produced steady stream of profits that enabled the executives reap high bonuses but when the tail risk materialised, which it does in long run, the shareholders and tax payers were the people who bore the brunt. This compensation policy that rewards short term profiteering is deeply flawed. It allows the creation of Ill be gone, youll be gone attitude where in executives only think about the short term gains and ignore the risk that their strategy entails in long run. This needs to be changed.

New models of compensation?

There has been a debate going around the world on how to fix the flaws with the compensation policies for the executives. Fixed pay compensation policy is definitely not the answer, as it will exacerbate the agency problem. The most credible alternative that has emerged out this debate is that, There has to be mechanism of deferred rewards. It entails that there will be a fixed pay and variable pay but the variable pay will be deferred over the period of time so that incentives of short term profiteering can be curtailed. There will be a escrow account or a claw back mechanism that will allow the shareholder to take back the compensation paid to the executives in case decisions made by the executives were knowingly detrimental to the long term stability and solvency of the company. There has to be transparency in compensation setting. Increasing shareholder oversight.

This model has some flaws. First, it takes away the incentives to innovate. And innovation is necessary in order to achieve maximum efficiency. A case of this is CDS. Though they have been blamed for the deepening of the financial crisis, CDS in itself was very good innovation that allowed companies and individuals to hedge against the credit risk. But in the years before the financial crisis, the concept of CDS was taken too far and perhaps also the correlation was underestimated. So, its not the innovation but the rampart usage of the instruments for the wrong purposes is something to prevent. Second issue with the above model is the determination whether a decision taken by the executive was taken in good faith or in bad faith. With the benefit of hindsight, it is very easy to say whether the decision was right but predicting the result accurately is very hard. And perhaps with claw back mechanism in place, executives will become extra cautious; perhaps more than necessary, and this will also be detrimental to the value of the shareholders. Perhaps a better model would be the one that ties the gains to risk that they entails. In my opinion, broadly speaking, the compensation of the executives should not only be linked to short-term profits and the price of the stock, but rather also to the stability and the improvement in the risk measures that they brings or employ. Going further, I will say that there should be a common fund to disperse the bonuses of the executives and risk managers and this dispersion should be on the competitive basis. This is a broad idea and development of this idea should be the topic of another paper.

Conclusion

In conclusion, high compensation of the executives emanates both from the rent extraction attitude as well the market competitiveness and this in turn gives rise to the exceedingly high pay. This high pay, though legitimate, poses a moral hazard to the greater well being of the society as it promotes the inequality in the society. Further, linking of the compensation with observable entity such as stock price does reduces the agency problem, but it also promotes the excessive risk taking and implementation of projects and decisions that bolster short term returns, sometime at the expense of longer term stability, as we have seen in the case of the financial institutions in the years leading to the financial crisis. There fore, any compensation policy that rewards this short term profiteering behaviours such as bonuses is a flawed compensation model. This model needs to be changed.

There have been various models of the compensation that have been advocated, including taxation, but the most credible among them has been that one that allows for deferred payment of bonuses and claw back mechanisms. But this model is not with out the flaws. It stifles innovation and perhaps also encourages overcautious approach by executives that will not at all in the benefit of the shareholders. Further, it can also be said that this model fails to link the compensation to effective risk management and perhaps best model would be the one that will link the compensation not only with stock prices but also with the stability and risk measure executives implement.