In 1998, the US economic system was threatened by the collapse of hedge fund Long Term Capital Management and the Federal Reserve had to rally around with a bailout package in excess of $3.6 billion (Rs16,668 crore today). This was explained as a once-in-a-century aberration needed to keep the markets afloat. This year, the US government has again bailed out Bear Stearns Companies Inc., Freddie Mac, Fannie Mae and American International Group Inc. with infusions of liquidity worth several hundred billion dollars. We now know, if ever there was a doubt, that large financial institutions do not live in the same world as other companies. Retailers and telecom companies may file for Chapter 11, but banks and brokerages will almost always have a safety net owing to their roles in intermediation and capital allocation.
This is neither wrong nor unfair. Organizations such as banks that support the basic flow of liquidity and allocation of risk perform a more basic function than many other sectors in the real economy and therefore do get treated differently.
While agreeing with these handouts, one would like more debate about the distorted incentive structures that have caused this crisis. Commentators have attributed the crisis to inanimate phenomena such as a domino effect, liquidity crunch or deleveraging. The truth, however, is that the crisis was caused by brilliant but callous banking chief executive officers (CEOs) who ran their businesses with leverage ratios consistently in excess of 25 times their capital, while knowing that this was unsustainable and held risks to the larger financial system. What is required now is an understanding of the compensation structures which caused a relatively small group of CEOs to participate in extraordinary risk-taking.
We believe that this blinkered approach to risk was driven by compensation structures unsuited to financial services companies. This sector is different and the persons who determine the destinies of banks need a different yardstick for compensation. More than any other sector, banking and financial services operate as a herd, have much higher levels of debt and have important stakeholders other than equity shareholders. These peculiarities require boards of financial institutions to fundamentally redesign stock-based compensation structures to reflect the interests of those who are really bearing the risk of their actions. This article suggests three changes that can help reduce the distortion of incentives.
Most CEOs are rewarded through the stock option-based compensation system which is intended to align the interests of the CEO with those of equity shareholders. This is fair because equity shareholders of most companies are the persons almost exclusively impacted by the CEOs’ appetite for risk. In contrast, in the case of large financial institutions, the rewards of success during the boom years were fully garnered by equity shareholders, but the losses of the downturn are borne by lenders and ultimately the government. If stock is a major part of a CEO’s compensation, such a situation can encourage excessive risk-taking since the CEO knows that he and his shareholders bear the upside benefits, but have a much smaller downside impact. Consequently, one could , at the outset, suggest that CEOs of financial institutions ought to have a lower extent of stock-based compensation than in other industries and be paid on measures such as long-term risk that impact other major stakeholders too.
Even if one were to limit the use of stock, it needs to be structured to avoid the volatilities caused by the herd behaviour so common to this sector. Such behaviour can increase the volatility of incomes and the risk profile of the firm far in excess of anything seen outside financial services. One cannot prevent the CEO from following the herd, since contrarian strategies often do not make money, but one can increase the element of compensation which is deferred much longer than for other industries and paid out about 36 months after the period under review.
After these big bailouts, none can deny that the downside risks in banks have much greater contagion effects than situations of financial distress in other sectors. When a retailer or a telco goes under, it does not necessarily bring down all its suppliers. In banking, there is the risk of a domino effect that can fell other banks and spread into the real economy. As we know that these organizations benefit from the safety net of the government, their CEOs have a greater social responsibility to get things right. Given that there is the privatization of profit but socialization of loss, the boards that govern these CEOs must play a larger role in ensuring the compensation plans actually reflect the larger economic costs reflected in the risk appetite of the bank.
Finally, it should be possible for companies to be able to claw back a portion of the deferred compensation to ensure that there is an incentive for the CEO and his team to maintain the right balance between risk and reward.
These should not be seen as an opportunistic, left-of-centre suggestions exploiting the current angst against those who led these institutions. The bipartisan Henry Waxman committee on government reform angrily grilled Stan O’Neal of Merrill Lynch and Co. and Chuck Prince of Citigroup Inc. about this several months ago. Raghuram Rajan, former chief economist at the International Monetary Fund, has also expressed concern about the camouflaging of the real risks in this sector. Now is the time to impose a clear reward structure that works and penalizes unwise risk-taking on such a scale.
Govind Sankaranarayanan is CFO, Tata Capital Ltd. He writes on issues related to governance. The views expressed in this column are personal.Write to him at firstname.lastname@example.org