Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Bankers’ pay and incentives

Much has been written about how (a) bankers’ pay is excessive
and (b) the incentive created by these pay structures encourage risk
taking. A lot of this discussion has treated bankers’ pay as a
corporate governance problem without considering the special
characteristics of banks. I was therefore delighted to read this paper by Bebchuk and
Spamann which is like a breath of fresh air.

Bebchuk and Spamann point out that because of the excessive
leverage of banks and the explicit and implicit support of the
government, the shareholders are incentivized to support excessive
risk taking. Therefore the standard corporate governance ideas of
aligning the interests of managers with that of shareholders are
useless when it comes to banking. They propose that regulators should
step in and require that incentives be linked to the total value of
the firm and not just the value of the equity.

Bebchuk and Spamann do not address the issue of bankers’ pay
being excessive though that has a similar explanation. Deposit
insurance and implicit government guarantees create the potential for
huge rents in banking. The only way to extract these rents is by
highly complex (and possibly deceptive) risk taking strategies that
get past regulatory restrictions. Implementing these strategies
therefore requires a great deal of expertise and skill which are in
short supply. Therefore when shareholders try to extract rents by
hiring smart people to implement complex risk taking strategies, most
of the rents are in fact extracted by the managers themselves. To view
this as a corporate governance problem is a mistake. It is a problem
of government policy that encourages rent seeking.

Bebchuk and Spamann also correctly point out that the managers
whose personal wealth has been destroyed by the collapse of their
banks were not necessarily stupid or ex ante irrational. Ex ante, they
could well have been responding correctly to the incentives that they
faced and the probabilities that they estimated.


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