Edited by Randall S. Thomas and Jennifer G. Hill
Chapter 7: Reforming Financial Executives’ Compensation for the Long Term
Sanjai Bhagat and Roberta Romano* 1 INTRODUCTION A myriad of factors have been identified as contributing to the ongoing global financial crisis, running the gamut from misguided government policies to an absence of market discipline of financial institutions that had inadequate or flawed risk-monitoring and incentive systems.1 Such government policies include low interest rates by the Federal Reserve and promotion of subprime risk-taking by government-sponsored entities dominating the residential mortgage market so as to increase home ownership by those who could not otherwise afford it, which fueled a housing bubble, and bank capital and institutional investor holding requirements dependent on credit ratings by entities which were either conflicted or incompetent (or both), providing triple-A ratings to securitized packages of subprime mortgages. Identified sources of inadequate market discipline include ownership restrictions, deposit insurance inducing moral hazard, ineffective prudential regulation including capital requirements that favored securitized subprime loans over more conventional assets, while internal organizational factors contributing to the crisis include business strategies dependent on high leverage and short-term financing of longterm assets, reliance on risk and valuation models with grossly unrealistic assumptions, and poorly designed incentive compensation. This myriad of factors, taken as a whole, encouraged what was, as can readily be observed with the benefit of hindsight, excessive risk-taking. Yet only one of the items on the long laundry list of factors contributing to the crisis has consistently been a focal point of the reform agenda across nations: executive compensation. In the United States, for example, multiple legislative and regulatory...
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