Bank CEO incentives and the credit crisis

This post is by René Stulz of Ohio State University.

In the search of explanations for the dramatic collapse of the stock market capitalization of much of the banking industry in the U.S. during the credit crisis, one prominent argument is that executives at banks had poor incentives. Rudiger Fahlenbrach and I have completed a working paper titled “Bank CEO incentives and the credit crisis” that investigates how closely the interests of the CEOs of banks were aligned with those of their shareholders before the start of the crisis, whether the alignment of interests between CEOs and shareholders can explain the performance of banks in the cross-section during the credit crisis, and how CEOs fared during the crisis. Traditionally, corporate governance experts and economists since Adam Smith have considered that management’s interests are better aligned with those of shareholders when managers’ compensation increases when shareholders gain and falls when shareholders lose. On average, bank CEOs had powerful incentives to maximize shareholder wealth as of 2006. We show that in our sample the median value of a CEOs equity stake (taking into account options) was $36 million. Typically, a CEO’s equity stake was worth more than ten times his compensation in 2006.

Our results show that there is no evidence that banks with a better alignment of CEOs’ interests with those of their shareholders had higher stock returns during the crisis and some evidence that banks led by CEOs whose interests were better aligned with those of their shareholders had worse stock returns and a worse return on equity. In particular, whether our sample includes investment banks or not, stock return and accounting equity return performance are negatively related to bank CEOs dollar incentives, measured as the dollar change in a CEOs wealth for a 1% change in the stock price. This effect is substantial and is not explained by a few banks where CEOs had extremely high ownership. An increase of one standard deviation in dollar ownership is associated with lower returns of 10.2%. Similarly, a bank’s return on equity in 2008 is negatively related to its CEO’s holdings of shares in 2006 – a one standard deviation increase in dollar ownership is associated with approximately a 10.1% lower return on equity. Though options have been blamed for leading to excessive risk-taking, there is no evidence in our sample that greater sensitivity of CEO pay to stock volatility led to worse stock returns during the credit crisis.

A plausible explanation for these findings is that CEOs focused on the interests of their shareholders in the build-up to the crisis and took actions that they believed the market would welcome. Ex post, these actions were costly to their banks and to themselves when they produced poor results. These poor results were not expected by the CEOs to the extent that they did not reduce or hedge their holdings of shares in anticipation of poor outcomes. Using data on insider trading to estimates sales of shares, we find that CEOs made extremely large losses on their holdings of shares in their bank because they typically did not sell shares. Further, CEOs made large losses on their options.

Our research shows that bank CEOs had very high incentives to maximize shareholder wealth. This evidence makes it implausible that the credit crisis can be blamed on a misalignment of incentives between CEOs and shareholders.

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  1. JGP
    Posted Thursday, August 6, 2009 at 12:58 pm | Permalink

    Interesting, but the authors have not challenged a basic premise that keeps failing and no one seems to want to step back study it.

    The premise that “… management’s interests are better aligned with those of shareholders when managers’ compensation increases when shareholders gain and falls when shareholders lose….” assumes, at it’s core, that managers make a difference and can influence outcomes.

    I’d suggest that the author’s do another study and begin with the premise that corporate agents – the managers of today’s public companies – don’t make a difference and manipulations of their compensation – as if they did make a difference – is a waste of time and share owner wealth.

    The subset to this is that these managers know they can’t control outcomes with any precision so they have have negotiated substantial compensation packages with boards who share in the fable that they can make a difference.

    The fable – managers make a difference – is an important lynch pin to the larger story that is so easy to spin but consitently fails – gotta pay ’em a lot. This may be the ‘flat earth belief’.

    It’s entirely possible that the better alignment with share owners in modern public corporations is to minimize total compensation to managers because, on average, they don’t make any difference. We could discover that the earth is round.

  2. Michael F. Martin
    Posted Thursday, August 6, 2009 at 6:43 pm | Permalink

    What this shows is that bank CEOs, as a group, had strong incentives to maximize profits for shareholders. But what matters in rewarding and punishing CEOs is not how the whole group of CEOs is given incentives, but how the relative incentives of a particular CEO compares to his or her peers.

  3. MHodak
    Posted Saturday, August 8, 2009 at 12:22 pm | Permalink

    This study accords extremely well to the anecdotal evidence that no one had a greater incentive to avoid the collapse of Bear or Lehman than their respective CEOs, who saw their personal fortunes all but wiped out on bets they very likely would not have condoned if they had really understood them.