Bankers' pay is behind excessive risk-taking

Do compensation plans for bankers encourage them to take on too much risk? The answer is yes, according a report released today by the International Monetary Fund that contradicts other research on the topic.

The IMF says bank executives are overly concerned with short-term progress because banks track their performance by measuring gross revenue, and that may result in hidden long-term costs. As a result, bankers may choose risky investments that can compromise the bank's solvency.

Investors, however, often applaud financial services firms that take these types of risks because of the huge potential rewards that could lift banks' share prices, if those risks don't blow up.

"The main conflicting interests, however, are between shareholders, managers, and debt holders on one side, and society at large on the other side," said the IMF. "They arise because of the presence of externalities related to systemic risk, and have long been a concern for regulators."

The picture, though, is complicated. Economists Rudiger Fahlenbrach and René M. Stulz noted in a 2010 paper that they didn't see any evidence that financial CEOs' judgment was clouded by their company's compensation practices.

"If CEOs took risks that they knew were not in the interests of their shareholders, we would expect them to have sold shares ahead of the crisis," they wrote. "We find that this did not happen. CEOs therefore made large losses on their holdings of shares and on their holdings of options. On average, CEOs in our sample lost at least $30 million and the median CEO loss is more than $5 million. "

Writing in a 2012 blog post on the World Bank's website, Stultz noted that the CEOs of Lehman Brothers and Bear Stearns had equity holdings in their firms in 2006 that were worth approximately $1 billion and that "it would have made little sense for CEOs to take actions that knowingly decreased shareholder wealth." Lehman collapsed during the financial crisis, and Bear Sterns wound up being sold to JPMorgan Chase (JPM).

Of course, some bank CEOs escaped the crisis with their fortunes largely intact.

Former Countrywide CEO Angelo Mozilo, for instance, earned $535 million between 1999 and 2008. Countrywide has been blamed for misleading investors about the quality of the mortgages that it bundled into securities and sold off. Mozilo isn't being charged criminally, although he has faced civil actions that have cost him millions in fines. Bank of America (BAC), which acquired Countrywide in 2008, agreed last month to pay a $16.65 billion fine because of the illegal activity that occurred at Mozilo's company.

JPMorgan CEO Jamie Dimon received a 74 percent pay increase in 2013, earning a restricted stock award of $18.5 million despite the myriad investigations involving the New York-based bank. Regulators cited inadequate risk-management practices as one of the reasons they fined JPMorgan $920 million after the "London Whale" trading losses. Dimon wasn't implicated personally for the company's costly error.

"Financial regulatory reform has gone a long way toward improving standards for governance and executive pay," said Gaston Gelos, chief of the IMF's Global Financial Stability Division, in a press release. "But in some areas we need to go further -- for example, by making executive compensation more sensitive to default risk and more dependent on longer-term outcomes. Bankers should be rewarded for creating long-term value, not for short-term bets."

Officials from the IMF couldn't immediately be reached for comment.

  • Jonathan Berr On Twitter»

    Jonathan Berr is an award-winning journalist and podcaster based in New Jersey whose main focus is on business and economic issues.