Whitehead

Policies to regulate executive pay contributed little to control how much non-executives were paid, how they performed and what risks they incurred for banks leading up to the 2007 financial crisis, according to a Cornell Law School professor.

In a recent paper, Charles K. Whitehead argues that policymakers are incorrect in presuming that high-level bank executives will bring junior employees’ compensation into line once their own pay is regulated.

Examples of risk-taking and losses by non-senior executives in the financial industry abound:

• Fabrice Tourre, a Goldman Sachs vice president, was found guilty Aug. 1 of securities fraud that caused three firms to lose $1 billion.
• Bruno Iksil, a JPMorgan Chase trader, caused losses of approximately $6.2 billion.
• Nick Leeson, a mid-level futures trader, incurred $1.3 billion in losses at Barings Bank, bringing about its collapse in the mid-1990s.

“Why then,” Whitehead asks, “has executive compensation been a principal focus of efforts to control bank risk?”

In his paper, he describes the period leading up to the 2007 financial crisis and how non-executive incentives were determined largely by market demand for talent, rather than being set by individual bank managers.

“We often think of competition as benefiting the marketplace,” Whitehead notes. “It forces companies to keep prices low and quality high or, in the case of staffing, it helps in allocating the best employees to the most profitable firms. But competition can also have its costs.”

Leading up to the financial crisis, competition diluted bank managers’ ability to set non-executive pay and contributed to the rise in risk-taking across the banking industry, he writes. Competition dominated the size of employees’ paychecks, failing to curb some non-executives who took significant risks that enhanced short-term performance and then moved on to new jobs before any losses materialized.

The paper argues for three regulatory changes. First, in assessing how bank employees are paid, regulators need to compare how similar employees are paid by hedge funds, investment banks and others who compete with banks for talent.

Second, to lower incentives for employees to take risks and switch jobs, bank non-executives should be restricted from moving to other financial employers for a period of time after leaving the bank.

Finally, employers should be restricted from compensating new hires for that portion of the compensation received from a prior employer that was tied to long-term performance.

A copy of the paper, “Risky Business: Competition, Compensation, and Risk-Taking,” is available online.