Should Governments Regulate The Compensation Of Executives

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An issue that raises the brows of the public is whether senior bank executive are 'overpaid' especially in improper periods (crisis) and whether their pay should be regulated by the government.

There is a large empirical literature and argument over the issue. Fahlenbrach and Stulz (2009) showed that bank CEOs were largely adversely affected wealth-wise by the crisis, there was no reduction in their share portion in expectation of the crisis and no evidence was found that they hedged their equity exposure. Felix Salmon (2010) argues that banks should be regulated by government knowing they control monetary policy brings better coordination. Sean Silverthorne (2009) also says that the boards and shareholder do not have enough incentives at hand to control bank executives pay therefore CEOs pay should be regulated. Bebchuk (2009) says that government intervention will reduce excessive risk-taking.

Reward and performance-evaluation is used to control incentive problems that arise between parties and regulatory constraints greatly influence a firm's strategy. Section 2 looks at the issues involved, section 3 evaluates based on theory, section 4 analyses the consequences of tighter pay and section 5 concludes the paper.

2. Subject of the matter

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Setting limits on bankers' compensation was a major issue discussed by financial regulators during the financial crisis which one of its believed causes was when large banks and investment firms in the United States began taking on so much risk; it was believed that excessive compensation favoured short-term performance leading to the excessive risk.

In 1965, the average CEO in the United States earned 24 times more than the average worker, the fall in the stock market in 2002 caused the pay to fall from 299 times in 2000 to 149 times in 2002, since then however it has exploded. In 2007, the average CEO in the United States earned 275 times more and by 2009 it was 550 times more.

Government is one of the largest shareholders of some major banks, having a huge percent of the voting shares. The government owns 70% of Royal Bank of Scotland and holds 43.4% stake in Lloyds Banking Group after having to bail them out. The aim for such intervention cited by Jones (2009) is to avoid banks becoming so big they know governments must intervene if they run into trouble so that the whole financial system is not disrupted and to allow proper cross-border supervision which encourages transparency.

3. Critical evaluation based on theory

Many agency relationships exist within a firm but since the incentive of both employer and employees are constantly in conflict, agency problems will always arise. To minimize such problems, monitoring and bonding costs have to be incurred by both parties. Shareholders are more risk-taking, while bank executives poise as risk-averse individuals and are faced with firm specific risk that cannot be diversified away. An optimal risk sharing point has to be reached where the employer is paid a compensating differential. Firms motivate employees by compensation packages seen as a combination of base salary, short-term and long-term incentives, deferred compensation and benefits. Compensation contract are designed to maximize employees value, output over cost and the firm's value making both parties better off. Good compensation packages can be paramount in attracting and retaining talented employees/executives since employees pay for their general training. But in a competitive market, paying employees more than the competitive rate in the long run could drive the company out of business. With restriction placed on compensation packages, it increases productivity, loyalty and ties executive pay to the firms' success or failure.

What of the error term that is unobservable? Sometimes more of environmental factors and less of executive effort lead to the firm's success or failure. An executive could gain from the general improvement in the environment rather than his effort. Likewise he could loose from bad performance of the environment rather than his own effort. Unfortunately, executive are still paid large compensation packages even when the firm performs badly because the separation of decision management and control where decisions of individual are meant to be monitored by individuals above them in the hierarchy is not effective especially at the topmost level.

Shareholders judge the firms performance based on profits and stock price, focusing on the current reporting period without considering the long-term impact of such decisions. Executives therefore feel compelled to come up with strategies (even if dysfunctional) that support the share price and profits in the short term rather than over a long term horizon. Most compensation packages need a job description to be able to evaluate, basing compensation on output, but since there is 'no particular' job description for manager, it involves a variety of task which makes compensation package difficult to evaluate. A balance has to be set between basic components of Organisational Architecture - The assignment of decision rights, the reward system and the structure of performance-evaluation to ensure the success of a firm.

4. Consequences of tighter pay

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Undesirable consequences would be triggered; highly qualified executives will prefer to function in non-regulated sectors and non-regulated countries which can grossly affect the growth and development of the financial sector and the overall economy. Managers will always find loopholes to outmanoeuvre the system since information asymmetry exist.

5. Conclusion

Can we trust the government do it right? Do they have enough capacity to manage the banks? A regulatory system needs calculated and strategic management. Industry analysts say government was purely 'dressing the shop window' when it outlined a draft to steer clear of another financial crisis. With the presence of asymmetric information will the government be fully aware or totally understand the steps taken within financial walls?

With the emergence of a global market, increased number of firms, new technology, the increasing urge to maximize shareholders value and knowing that healthy financial institution promote economic development and growth, competition is needed and compensation should be influenced by market force. Also, the involvement of large shareholders in monitoring and controlling firms' activities has the ability to reduce agency problems. Bertrand and Mullainathan (2001) found that the presence of large shareholders on the board is associated with tighter control over executive compensation.

A group of academics recommend that key financial institutions should hold back a fraction of executive's annual compensation for several years and if the firm goes bankrupt or it receives assistance from the government, such fraction should be forfeited. In all, executives should take a lesson from Citibank CEO Vikram S. Pandit who voluntarily cut his annual pay in 2009 to $1, down from more than $38 million the year before vowing not to take a raise or incentive compensation until Citi returns to fertility. Business Week (2010).

REFERENCING

Bebchuk, L. (2009) Regulate Financial Pay to Reduce Risk-Taking. [Online] London, Financial times. Available from http://www.ft.com/cms/s/0/e34d6d4e-8058-11de-bf04-00144feabdc0.html [Accessed 2nd April, 2010].

Bebchuk, L. and H. Spamann (2009), Regulating bankers' pay, Georgetown Law Journal, Vol. 98, No. 2, pp. 247-287, 2010, and Harvard Law and Economics Discussion Paper No. 641

Bertrand, M. & Mullainathan, S. (2001) Are CEOs Rewarded for luck? The Ones Without Principals Are, Quarterly Journal of Economics Vol 116, No. 3, 901-932.

Brickley, Smith & Zimmerman (2008) Managerial Economics and Organizational Architecture, 5th edition, New York, McGraw-Hill Irwin Publishing.

Fahlenbrach, R. and R. Stulz (2009), Bank CEO Incentives and the Credit Crisis, Fisher College of Business Working Paper No. 2009-03-13

Jones, H. (2009) Tighter Bank Regulation Plans Unveiled. [Online] London. Microsoft Publication. Available from http://money.uk.msn.com/current-accounts/articles.aspx?cp-documentid=148831994. [Accessed 23rd March, 2010].

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Roberts, J. (2004) The Modern Firm, Organisational Design for Performance and Growth. New York, Oxford University Press.

Ridley, K. and Holton, K. (2009) Banks urge Regulators to harmonise Rules [Online] New York, Thomson Reuters Publishing. Available from http://uk.reuters.com/article/idUKTRE5675B220090708. [Accessed 2nd April, 2010]

Salmon, F. (2010) Why the Fed should regulate banks. [Online] New York, Thomson Reuters Publishing. Available from http://blogs.reuters.com/felix-salmon/2010/01/19/why-the-fed-should-regulate-banks/ [Accessed 20th March, 2010].

Silverthorne, S. (2009) Government Should Regulate executive Pay. [Online] London, CBS Interactive. Available from http://blogs.bnet.com/harvard/?p=3249 [Accessed 22nd March, 2010].

Silver-Greenberg, J., Kalwarski, T. and Leondis, A. (2010) CEO pay drops, but Cash is King. [Online] London, Business week. Available from http://www.msnbc.msn.com/id/36054052/ns/business-us_business// [Accessed April 8th, 2010].

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