The folly of paying bankers in shares
It’s bonus time for the heads of our big banks. Stephen Hester is getting £2m in RBS shares. My old friend Bob Diamond is reported to be set for £9.5m at Barclays. The outgoing head of Lloyds, Eric Daniels, is pondering whether to take the £1.45m he has been offered. HSBC is due to report soon.
It’s still quite common to hear the argument that executive pay at large banks did not have anything to do with the 2008 meltdown and that anyway, since bonuses have to be mostly paid in shares nowadays, there is no problem with misaligned incentives.
I thought it might be useful to link to two pieces of research that suggest otherwise.
The first is by Lucian Bebchuk and Roger Spamann of Harvard Law School and Alma Cohen of Tel Aviv University
The authors shoot down the argument that because the heads of Lehman Brothers and Bear Stearns had large holdings of shares in their banks when the crash happened, the bosses did just as badly as the rest of the banks’ shareholders:
“Based on information contained in executives’ filings of their trades, we estimate that during 2000-2008 the top-five executive teams at Bear Stearns and Lehman cashed out total amounts of about $1.1 billion and $850 million respectively. Indeed, we find that during the years preceding the firms’ collapse, each of the teams sold more shares than they held when the music stopped in 2008.”
This is the authors’ conclusion:
“The top executives of those two firms were not financially devastated by their management of the firms during 2000-2008. They were able to cash out large amounts of performance-based compensation, both from bonuses and from share sale, during the years preceding the firms’ collapse. This cashed-out performance-based compensation was large enough to make up the losses on the executives’ initial holdings in the beginning of the period. As a result, the executives’ net pay-offs from their leadership of the firm during 2000-2008 were decidedly positive.”
The second relevant piece of research is by Sanjai Bhagat of the University of Colorado and Brian Bolton of the University of New Hampshire.
Examining the disposals and acquisitions by 14 Wall Street CEOs of their own bank’s stock between 2000 and 2008, Bhagat and Bolton find these banking chiefs were 30 times more likely to be sellers than buyers. And while they purchased shares worth $36 million over that period, they sold shares worth $3.54bn. These were chefs that weren’t terribly keen on eating their own cooking.
The Bhagat and Bolton also suggest that the manner in which these banking executives were paid encouraged them to behave recklessly. The authors argue that bank chiefs who were awarded huge share bonuses had a clear personal financial incentive to load up their banks’ balance sheets with lucrative risk:
“If during the first few years of this [risky] trading strategy the cash flow outcomes have been positive and the CEO has liquidated significant amount of stock holdings, even when the bank faces bankruptcy in a future year, the CEO’s personal fortune may well be still quite substantial.”
In other words, paying executives in shares means they can cash out before the bad loan chickens come home to roost.
Incidentally, the International Monetary Fund now agrees that bankers’ pay played a part in causing the crash. An evaluation paper of the Fund’s pre-crash analysis of the UK economy concludes (p3):
“The search for yield and acceptance of higher risk was in part driven by banks’ compensation packages for their staff that in effect rewarded undue risk taking.”
Bhagat and Bolton recommend that, if bank chiefs must get huge share bonuses, they should not be able to sell those shares until three years after they leave the bank.
But the present UK Financial Services Authority and the global Financial Stability Board rules on disposals are nowhere near that tough. The most rigorous stipulation in the FSA’s 2009 code on bonuses is that the deferred element of share bonuses should not vest for three years. The FSB 2009 guidelines says the same (p3) . If those rules had been in place in 2000, it would still have been in the financial interests of bankers to fill their boots at the expense of shareholders since the boom had another seven years to run.
So here’s two thoughts to take into the bonus season. 1) Paying bonuses to bankers in shares does not automatically align the interests of bankers with shareholders. 2) The new safeguards on when they get access to those shares are probably too weak to make any substantive difference to bankers’ irresponsible risk-taking behaviour.Tagged in: bankers, barclays, Bebchuk, bob diamond, bonuses, deferred, HSBC, pay, shares, Stephen Hester
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