For over a month, I have been writing a paper on the role of executive compensation in causing the financial crisis. The following briefly summarizes a few of my findings:
High Pay: So What?
The fact that an executive receives sums of money so large that they are incomprehensible to the overwhelming majority of the world population does not mean that an executive is overpaid or unfairly paid. If executives increased the profitability of a corporation in a way that is sustainable, on what basis could someone object to executives being compensated for their performance? Consider the following:
Suppose that the intrinsic going concern value of Corporation X is $1 Billion. Now suppose that Executive Team A increases the intrinsic going concern value to $2 Billion. Further suppose that the next best executive team, Executive Team B, would have only increased the value of Corporation X by $250 Million and demanded $50 million in compensation. If Executive Team A is paid $700 Million, on what basis are they overcompensated?
While my aforementioned example is a useful theoretical tool, in practice valuing an executive is incredibly difficult. This is because human labor does not lend itself to a completely objective valuation. Executive compensation is a product of the bargaining process, where a decision is reached based upon what the corporation is willing to give, based upon their subjective valuation of an executive, and what the director is willing to accept. Therefore, what is unfair about the compensation decision? The decision is approved by the shareholders who are the ones who pay the executives’ salaries by way of lost earnings. It is further important to realize that $20 million to a major financial institution is not a significant sum.
The modern theory of the corporation is that proposed by Berle-Means. Under this theory, a corporation is an entity, owned by its’ shareholders, whose sole purpose is to earn profits for their shareholders. Therefore, directors and executives are approved, along with their compensation, by shareholders. Unless you are a shareholder in a corporation you have no right to complain about the compensation of an executive.
Even if an executive makes poor business decisions and causes a corporation to become bankrupt, an executive is hired and compensated based on the belief that they have the greatest chance of maximizing the value of a corporation and the least chance of destroying it. Errors in judgment are not preventable.
The “Systemic Risk Theory”
While the actions of financial executives have certainly, albeit indirectly, caused substantial difficulties for many people and greatly harmed the international economy, to adjust compensation levels because of the effects on non-shareholders, requires a complete upheaval of our capitalist system. First, it would impede upon the private right of contract. Second, under this argument, it would be totally justified to substantially confine compensation for jobs that are viewed not to convey substantial society benefits. For instance how would you feel if Congress decided that you profession was frivolous and capped your compensation at minimum wage.
Conspiracy Theorists Debunked
Widespread blame for the current financial crisis has been placed upon “those greedy executives” who knowingly undertook activities that would lead to large short-term gains and even larger long-term losses, in order to greatly profit. An earlier post denoted Richard S. Fuld, Jr., the Chairman and CEO of Lehman Brothers as the “Poster Child” for problems with executive compensation. An analysis of Mr. Fulds’ compensation reveals that he did not profit from Lehmans’ subprime activities and that he actually lost money. The compensation received. By Mr. Fuld, before and during Lehmans’ subprime activities was not materially different. Before Lehman’s subprime activities, Lehmans’ stock was trading around $35 per share. As the result of Lehmans’ subprime activities, Mr. Fuld sold ½ of his shares at inflated prices and ½ of his shares the deflated price of less than $0.50 per share for a total of roughly $270 million. If Mr. Fuld had sold his shares at a price of $35, he would have also received $270 million. Therefore Mr. Fuld did not profit. In fact, because the shares and options issued to Mr. Fuld after 2002 had not vested, Mr. Fuld lost a several hundred million dollars. The amounts of Mr. Fulds’ losses are even greater when considered the non-receipt of compensation resulting from Lehman’s non-existence.
James E. Cayne, lost substantially more than Mr. Fuld because while Mr. Fuld received the same amount of compensation as he would have if the price of Lehman stock remained at the same level as it was prior to the engagement of subprime activities, if Bear Stearns price had done the same, Mr, Cayne would have received an additional $350 Million.
Competition and Market Share: The Real Causes
A paper by Demirgüç-Kunt and Detragiache identifies 30 major banking crises within the last thirty years. The majority of these crises appear to have followed a common pattern. First, deregulatory measures lead to an increase in competition. The increase in competition decreases the market share enjoyed by the previously less regulated entities, usually investment banks, as the result of the previously more regulated entities, usually commercial banks entrance into the market. In order to maintain their overall level of market share, investment banks are forced to enter into new and scarcely used domain of securities activities, which entail more risk. The new activities result in a sudden credit expansion, which in turn create an asset bubble. The crisis results after the bubble bursts because the dramatic fall in prices results in overinvestment, which results in an increase in non-performing loans and other credit losses. These losses cause widespread bankruptcies and a banking crisis.
Our crisis follows an identical pattern. Deregulation came in the form of Gramm-Leach Bliley Act of 1999 which allowed commercial banks to engage in investment banking and insurance activities. The pressure on investment banks to increase market share was largely compounded by the burst of the “Tech Bubble” which meant a loss of tremendous profits in the form of IPO underwriting fees and Venture Capital investment in technology firms. The need to maintain market share resulted in an increase in subprime activities. This increased credit because subprime loans provided a plentiful source of credit to those who previously were unable to obtain any. This led to the housing bubble and the rest is history.
As mentioned in this forum, executives in other countries do not get paid nearly as much as they do in the US. This fails to consider that foreign executives are not paid in stock options. This means that if a corporation was to perform poorly or average this gap would be largely closed. Yet in these other countries there were many identical financial crisis where such adverse incentives did not exist. For example in Japan, CEO’s are paid $500,000 per year. In 1996 during the Jusen crisis, which almost toppled the Japanese Ministry of Finance, CEO’s made $250,000. In Japan the reward of being a CEO is the societal prestige accompanied by such a position. This means that a Japanese executive would have every incentive not to engage in activities that lead to large short term profits and larger long term losses because to do so would cripple their reputation. Yet, the Jusen crisis, which is identical to our current crisis, still plagued Japan.
CITATIONS:
Charles M. Elson, Executive Overcompensation—A Broad Based Solution, 34 B.C. L. Rev. 937, 945, (1993)
Demirgüç-Kunt, A., and Detragiache, E. (1998), ‘Financial Liberalization and Financial Fragility’, Working Paper 98/83, Washington, DC, International Monetary Fund.
Peter Englund, The Swedish Banking Crisis: Roots and Consequences, Oxford Review Of Exonomic Policy, Vol. 15, No. 3 (1999) at 81-82
Curtis J. Milhaupt & Geoffrey P. Miller, Japanese Financial Regulation as Seen From the “Jusen Problem” 26 (1997) at 19-21.
See Noelle T. Heintz and Robert M. Travisano, What is Past is Prologue: Why Congress Should Reject Current Financial Reform Bills and Breathe New Life Into Glass-Steagall, 373 STJJLC 381-382 (Winter 1998);