NCPA - National Center for Policy Analysis

Mandatory Long-Term Compensation in the Banking System

October 13, 2011

The past decade has witnessed a complete turnaround in academic thought on executive pay.  Prior to 2008, the leading school of thought was that corporate executives were too comfortable and that their compensation should be tied more tightly to the performance of their firms.  However, in the economic fallout of the financial panic, the leading school of thought on executive compensation has shifted from prescribing greater performance-based compensation to prescribing compensation systems designed to limit risk-taking and managerial short-termism, says James C. Spindler, the Sylvan Lang Professor of Law at the University of Texas School of Law.

To this end, experts advocate three separate techniques in order to better align the interests of corporate executives with shareholders.

  • First, restricted equity grants would continue to compensate executives with stock options in the firm, but they would limit the ability of the executive to sell them.
  • Second, implementation of "clawbacks" would create a more symmetric bonus structure. This would require that bonuses be held in a trust over a few years so that losses can be extracted from previously-earned bonuses.
  • Third, portions of this compensation, either equity or bonuses, should be held for several years after the end of tenure so that it can be divested upon the discovery of malfeasance or fraud.

While theoretically sound, these three techniques have potential costs that are often ignored.

  • First, restricting equity grants incentivizes executives to manipulate the timing of firm decisions for their own benefit.
  • Second, these techniques would drastically reduce attention paid to short-term results.
  • Finally, implementation of the clawback system calls into question what can and cannot be deemed a failure that warrants compensation penalties.

Source: James C. Spindler, "Mandatory Long-Term Compensation in the Banking System -- and Beyond?" Regulation Magazine, Fall 2011.

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