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Tuesday, January 19, 2010

Is It Time for Obama to "Pick a Fight with the Banks"?

I don't put much of the blame for the financial crisis on the bad incentives embedded in executive pay structures. But that doesn't meant that pay structures didn't contribute to the problem. And it certainly doesn't mean that executive pay is justified by productivity, or that there are no important market failures associated with the way executive pay is structured:

The CEO Pay Slice, by Lucian Bebchuk, Martijn Cremers, and Urs Peyer, Commentary, Project Syndicate: ...In our recent research, we studied the distribution of pay among top executives in publicly traded companies... Our analysis focused on the CEO “pay slice” – that is, the CEO’s share of the aggregate compensation such firms award to their top five executives.
We found that the pay slice of CEOs has been increasing over time. Not only has compensation of the top five executives been increasing, but CEOs have been capturing an increasing proportion of it. The average CEO’s pay slice is about 35%,... typically ... more than twice the average pay received by the other top four executives. Moreover, we found that the CEO’s pay slice is related to many aspects of firms’ performance and behavior.
To begin, firms with a higher CEO pay slice generate lower value for their investors..., such firms have lower market capitalization for a given book value. ... Moreover, firms with a high CEO pay slice are associated with lower profitability. ...
What makes firms with a higher CEO pay slice generate lower value for investors? We found that the CEO pay slice is associated with several dimensions of company behavior and performance that are commonly viewed as reflecting governance problems.
First, firms with a high CEO pay slice tend to make worse acquisition decisions. ... Second, such firms are more likely to reward their CEOs for “luck.” They are more likely to increase CEO compensation when the industry’s prospects improve for reasons unrelated to the CEO’s own performance... Financial economists view such luck-based compensation as a sign of governance problems.
Third, a higher CEO pay slice is associated with weaker accountability for poor performance. In firms with a high CEO pay slice, the probability of a CEO turnover after bad performance ... is lower. ... Finally, firms with a higher CEO pay slice are more likely to provide their CEO with option grants that turn out to be opportunistically timed. ...
What explains this emerging pattern? Some CEOs take an especially large slice ... because of their special abilities... But the ability of some CEOs to capture an especially high slice might reflect undue power and influence over the company’s decision-making. As long as the latter factor plays a significant role, the CEO pay slice partly reflects governance problems. ...
[O]ur evidence indicates that, on average, a high CEO pay slice may signal governance problems that might not otherwise be readily visible. Investors and corporate boards would thus do well to pay close attention not only to the compensation captured by the firms’ top executives, but also to how this compensation is divided among them.

Which opens the door to ask the question, is it time for Obama to pick a fight with the banks?:

Whatever happens today in Massachusetts, finding 60 votes in the Senate for meaningful financial regulatory reform is likely impossible. That means it is now high time to jettison the middle road, and go full bore against the banks. Given Obama's cautious approach so far in his administration, it is difficult to feel any confidence in such a prospect, but really, at this point one has to ask, what's he got to lose?

We've got a lot to lose if we don't get meaningful financial reform, so just as with health care, if what we can get through Congress actually improves conditions in financial markets, we need to take what we can get and hope to build upon it later. The question is how to construct a political strategy that will allow us to get as much done as possible. It may be that aggressively going after big banks can create public support for reform, support that would be difficult for politicians of either party to ignore. But there's also a chance that such a strategy will harden the resolve of those now opposed to reform making it harder to get anything done at all.

So a second question is whether the baseline level of reform we could get without an all out, "jettison the middle road" strategy is acceptable, If it is, I'd prefer to protect that and proceed cautiously. My loss function is asymmetric. Getting something, even if it isn't as much as we'd like, is much better than nothing at all.

But my sense is that right now the administration can't get enough support to do anything except fairly cosmetic changes. If that's the case, and I'm not completely sure that it is, but if so, then hammering the big banks relentlessly may be the only chance we have to create the coalition needed to implement more meaningful measures.

    Posted by on Tuesday, January 19, 2010 at 12:24 PM in Economics, Financial System, Market Failure, Politics, Regulation | Permalink  Comments (30)


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