Financial Crisis, Corporate Governance, and Bank Capital

Sanjai Bhagat is Provost Professor of Finance at the University of Colorado Boulder Leeds School of Business. This post is based on Professor Bhagat’s recent book.

Despite Dodd-Frank’s stated intentions to make “too-big-to-fail” banks a thing of the past, investors and policymakers believe that many big banks are still too big to fail. This issue has come up repeatedly in economic discussions in Congressional hearings, and among senior policymakers in the United States and Europe. In recent work, we propose a solution to the too-big-to-fail problem that can be implemented with minimal or no additional regulations, only the intervention of corporate board members and institutional investors in these big banks.

While some have argued that incentives generated by executive compensation programs led to excessive risk-taking by banks contributing to the 2008 financial crisis, there are more important causes of the financial crisis of 2008. Specifically, public policies regarding home mortgages are perhaps the single most important cause of the financial crisis of 2008. As is the case with most public policies, the intent of public policies regarding home mortgages was honorable—its goal was to increase home ownership by those who could not otherwise afford home mortgages. However, these public policies also encouraged an incentive compensation structure in the big banks focused on generating short-term profits at the cost of large longer-term losses.

We find that incentives generated by bank executives’ compensation programs contributed to excessive risk taking. To address these misaligned incentives, we recommend the following compensation structure for bank executives: incentive compensation should consist only of restricted stock and restricted stock options—restricted in the sense that the executive cannot sell the shares or exercise the options for one to three years after his or her last day in office. Also, we recommend incentive compensation for bank directors should consist only of restricted stock and restricted stock options—restricted in the sense that the director cannot sell the shares or exercise the options for one to three years after his or her last board meeting. This incentive compensation package will focus bank managers’ and directors’ attention on the long run and discourage them from investing in high-risk, value-destroying projects. We provide solutions to many of the caveats that arise, specifically regarding under-diversification and loss of liquidity for these executives and directors.

Our recommendation for executive (and director) compensation is based on our analysis of compensation structure in banks. The aforementioned equity-based incentive programs lose their effectiveness in motivating managers (and directors) to enhance shareholder value as a bank’s equity value approaches zero (as they did for the too-big-to-fail banks in 2008). Additionally, our evidence suggests that bank CEOs sell significantly greater amounts of their stock as the bank’s equity capital (tangible common-stock-to-total-assets ratio) decreases. Hence, for equity-based incentive structures to be effective, banks should be financed with considerably more equity than they are being financed currently. Our bank capital proposal has two components. First, bank capital should be calibrated to the ratio of tangible common equity to total assets (i.e., to total assets independent of risk) not the risk-weighted capital approach that is at the core of Basel. Second, bank capital should be at least 20% of total assets.

Greater equity financing of banks coupled with the aforementioned compensation structure for bank managers and directors will drastically diminish the likelihood of a bank falling into financial distress; this will effectively address the too-big-to-fail problem and the Volcker Rule implementation. If policymakers wish to repeal Dodd-Frank, yet address its worthy objectives, that is, the safety, resilience, efficiency, and transparency of our financial system, our market-based solution (greater bank equity, and reforming bank executive and director incentive compensation) should be given careful consideration.

Recently, the US House Financial Services Committee released a discussion draft of the Financial CHOICE (Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs) Act. The Financial CHOICE Act allows banks that have a leverage ratio of at least 10% to elect exemption from Basel III capital and liquidity standards and the Dodd-Frank Act Section 165 heightened prudential standards. The denominator of this leverage ratio would include total balance-sheet and off-balance-sheet assets; importantly, these total assets would be independent of risk.

We applaud this proposal of the Financial CHOICE Act. The simple capital measure presented by the aforementioned leverage ratio (where the total assets in the denominator are independent of risk) would restrict banks’ ability to engage in complex manipulation across risk weights and assets to minimize the equity in their capital structure. The proposal of the Financial CHOICE Act provides another benefit; that is, because the denominator would include off-balance-sheet items of structured investment vehicles, it would dampen concerns with the shadow banking system. The proposal of the Financial CHOICE Act is consistent with our market-based proposal; notably, its focus on simplicity, transparency, and requiring the denominator of the leverage ratio be total assets independent of risk and include total balance-sheet and off-balance-sheet assets.

The book is available for purchase here.

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