Evidence suggests top bank execs were fully aware of the risks they took, but drove on in search of greater reward for themselves, Simon Johnson writes.
By SIMON JOHNSON
One view of executives at our largest banks in the run-up to the crisis of 2008 is that they were hapless fools. Unaware of how financial innovation had created toxic products and made the system fundamentally unstable, they blithely piled on more debt and inadvertently took on greater risks.
The alternative view is that these people were more knaves than fools. They understood to a large degree what they and their companies were doing, and they kept at it up until the last minute â€“ and in some cases beyond â€“ because of the incentives they might receive.
New evidence in favor of the second interpretation has just become available, thanks to the efforts of Sanjai Bhagat and Brian Bolton, who went carefully through the compensation structure of executives at the top 14 financial institutions in the United States from 2000 to 2008.
The key finding is that chief executives were â€œ30 times more likely to be involved in a sell trade compared with an open-market buy tradeâ€ of their own bankâ€™s stock and â€œthe dollar value of sales of stock by bank C.E.O.â€™s of their own bankâ€™s stock is about 100 times the dollar value of open market buys.â€ (See page 4 of the report.)
If the chief executives had really believed in what their banks were doing, they would have wanted to hold this stock â€” or even buy more. Disproportionately, more sales than purchases strongly suggests that the chief executives felt their stock was more likely overvalued than undervalued.
The problem runs deeper, as Professors Bhagat and Bolton explain. Given the compensation structure of chief executives â€” particularly the fact that they can sell stock with very little restriction â€” they have an incentive to take on excessive levels of risk. When the outcomes are good, as they may be for a while in an up market, the chief executive can turn his or her stock into cash.
When the outcomes are bad, the chief executive doesnâ€™t care so much because he or she already has cash â€” and some form of government bailout or other support may be forthcoming.
Professors Bhagat and Bolton argue that if this incentive problem is important, we should see chief executives make a great deal of money while long-term buy-and-hold shareholders lose money.
Table 4 in their paper (Pages 45-48) shows the amounts of money involved, and they are simply staggering. Collectively, the people who headed these 14 institutions pocketed â€” in hard cash terms â€” more than $2.6 billion during 2000-8. Itâ€™s true that the paper value of their wealth dropped in 2008, although this was an unrealized paper loss. Even including that notional loss, the chief executives made an impressive $650 million profit.
In contrast, long-term shareholders in these 14 banks did very badly, particularly in 2008 (see Figure 1 on Page 61 of the paper). Professors Bhagat and Bolton show that shareholders in the biggest banks â€” where chief executives got their hands on more cash â€” did significantly worse than investors in smaller banks.
Interestingly, chief executives in the smallest banks in their sample did not sell much stock relative to their purchases of their own bankâ€™s stock. The big bank-small bank contrast is quite striking.
This points the authors toward moderate but appealing changes in executive compensation practices: â€œExecutive incentive compensation should only consist of restricted stock and restricted stock options â€” restricted in the sense that the executive cannot sell the shares or exercise the options for two to four years after their last day in office.â€
With regard to the need to increase the equity financing of all banks, the authors comment:
As a bankâ€™s equity value approaches zero (as they did for some banks in 2008), equity-based incentive programs lose their effectiveness in motivating managers to enhance shareholder value. Hence, for equity-based incentive structures to be effective, banks should be financed with considerably more equity than they are being financed currently.
This recommendation puts the authors on very much on the same page as Professors Anat Admati, Peter DeMarzo, Martin Hellwig and Paul Pfleiderer and many others in the finance profession. It should adopted by all shareholders and their representatives.
But who devised and negotiated the compensation packages at issue here, and who is in charge going forward?
The executives in question hire people like Steven Eckhaus, a top Wall Street compensation lawyer, who puts up a spirited defense of current practices and insisted to The Wall Street Journal just last weekend that â€œto blame Wall Street for the financial meltdown is absurd.â€
There is no sign that financial sector executives making decisions at our largest banks â€” and supposedly acting in the interests of shareholders â€” are at all interested in being compensated in a more responsible fashion that would better protect shareholder value. They want to get the cash out at every opportunity.
Boards comply; the breakdown in corporate governance in this respect is complete.
The only fools here are the shareholders â€“ and the rest of society that buys into such a foolhardy scheme.