Economists Alex Edmans at Wharton, Xavier Gabaix and Tomasz Sadzik at NYU and Yuliy Sannikov at Princeton have come out with a new paper regarding executive compensation at financial firms. The ideas strike us as being unworkable, primarily because they don't reflect the way things really work, and leave out a much simpler fix.
The economists argue for what they call “dynamic incentive accounts.” In their plan, top managers’ compensation would be placed into escrow accounts that would be invested in company stock and cash. Each month the account would be rebalanced, so if it were 60% in stock, and the company’s stock price fell, cash would be drawn down in the account to buy more stock. This would ensure that managers had skin in the company’s stock price even after the firm’s value fell. And it would take away the common problem of managers’ stock options getting repriced lower after a decline, which in essence rewards them for failure.
Also each month, a fraction of the incentive account would vest and be paid out to the manager. After leaving the firm, the account would continue to vest slowly, only getting fully paid out after a number of years. This would prevent the problem of CEO’s pushing for short-term gains as they retire, leaving their successor — and shareholders — holding the bag.
We disagree with these ideas because what really happened in this cycle was that executives at many financial firms were paid for paper profits; profits made when the value of a firms' holdings were priced up but not yet sold. That obviously leaves the danger that the value of the holdings can fall after incentives have been paid out, which heightens the moral hazard risk.
So regulation should be directed paying out bonuses only after profits have actually realized from the sale of positions. That would incentivize firms to trade more carefully because it would keep their skin in the game until an actual profit has been made, while allowing firms to take the market risks which are necessary for an expanding economy.
In line with G20 mandates, The Bank of Japan said it may provide as much as 1 trillion yen ($10 billion) of subordinated loans to banks to replenish capital depleted by falling stock prices and revive lending.
The central bank will provide details of the “extremely extraordinary” measure, the length of the loans and the interest rate it will charge “as soon as possible,” Governor Masaaki Shirakawa told reporters in Tokyo today.
“The program is aimed at preventing a situation where financial institutions become more cautious because of falling stock prices,” Shirakawa said. “We haven’t observed a major tightening in lending by banks.”
According to the statement released after the meeting, the key priority of the G20 will now be to restore lending by tackling, where needed, problems in the financial system head on, through continued liquidity support, bank recapitalization and dealing with impaired assets, through a common framework.
Officials released a three-page framework for financial repair and recovery aimed at restoring bank lending. Possible actions it listed included providing liquidity through government guarantees, injecting capital into banks, safeguarding deposits, and addressing impaired assets.
In the past two days Japanese bank stocks surged on speculation the central bank was considering the subordinated loan program. The Nikkei has advanced 5 percent this week.
The Bank of Japan concludes a two-day policy meeting tomorrow. Policy makers may then announce an increase in the amount of government bonds it buys from lenders as Prime Minister Taro Aso prepares a third stimulus package to ease the nation’s recession, according to economists.
More purchases of Japan’s government bonds would help avert a jump in bond yields, which have risen on concern that the government will have to sell more debt to pay for the stimulus. The yield on the benchmark 10-year bond rose to 13 basis points to 1.295% at yesterday’s close from 1.165%.