Elgar Financial Law series
Chapter 6: Post-Crisis reform to executive compensation at financial institutions
The previous chapter observed that the GFC was caused to some extent by a flawed understanding of the operation of financial markets and poor incentives in executive compensation contracts. Compensation systems at banks remained largely unfettered until the banking collapses of 2008. Of course, on the basis of those collapses, severe doubt was cast on the capacity of market discipline to act as an effective tool in constraining harmful risk taking, and on the provisions of existing legislation to regulate risks generated by executive compensation structures at financial firms. The view that poor incentives and insider rent seeking were partly to blame for the eruption of the crisis is supported by analysis of the events. Euphoric financial conditions combined with behavioural biases to drive an increase in credit expansion and leverage. The risk management systems and compensation structures at financial institutions were skewed heavily in favour of increased lending volumes and weak due diligence. Executives were rewarded for achieving short-term earnings targets even where earnings from these trades evaporated and it became clear that risk had been underestimated. On this basis, executive compensation reform has been placed at the heart of the regulatory response to the GFC. Accordingly, the regulatory response to these factors will be analysed in this chapter, which will conduct an examination of the reforms to executive compensation post-GFC produced by national and global regulators.
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