The following post comes to us from Frederick Tung, Professor of Law at Boston University, and M. Todd Henderson, Professor of Law at the University of Chicago. Related works by the Program on Corporate Governance on the subject of pay incentives to avoid excessive risk-taking include Regulating Bankers’ Pay by Bebchuk and Spamann, Paying for Long-Term Performance by Bebchuk and Fried, and How to Fix Bankers’ Pay by Bebchuk.
Few doubt that executive compensation arrangements encouraged the excessive risk taking by banks that led to the recent Financial Crisis. Accordingly, academics and lawmakers have called for the reform of banker pay practices. In our paper, Pay for Regulator Performance, forthcoming in the Southern California Law Review, we argue that regulator pay is to blame as well, and that fixing it may be easier and more effective than reforming banker pay. Regulatory failures during the Financial Crisis resulted at least in part from a lack of sufficient incentives for examiners to act aggressively to prevent excessive risk. Bank regulators are rarely paid for performance. They are paid a fixed salary that does not depend on whether their actions improve banks’ performance, protect banks from failure, or increase social welfare.
We propose instead that regulators, specifically bank examiners, be compensated with a debt-heavy mix of phantom bank equity and debt, as well as a separate bonus linked to the timing of the decision to shut down a bank. [1] Giving examiners a stake in bank performance, both upside and downside, will improve their incentives to act in the public interest. A pay-for-performance culture will work better for bank examiners than other bureaucrats because of the objective metrics (i.e., stock and debt prices) available that directly track social welfare outcomes. We do not discount the value of public spiritedness as an inducement toward good regulatory performance. We also believe, however, that monetary incentives tied objectively to socially desirable outcomes could improve examiner incentives, especially given the failure of existing inducements in the run-up to the Financial Crisis.
