Arnold Kling  

Compensation of Bank Executives

Peter Berkowitz on Elites... Jewish versus Chinese Parentin...

Simon Johnson writes,

New evidence in favor of the second interpretation [that bank executives were evil] has just become available, thanks to the efforts of Sanjai Bhagat and Brian Bolton. These researchers went carefully through the compensation structure of executives at the top 14 US financial institutions during 2000-2008.

The key finding is that CEOs were "30 times more likely to be involved in a sell trade compared to an open market buy trade" of their own bank's stock and "The dollar value of sales of stock by bank CEOs of their own bank's stock is about 100 times the dollar value of open market buys"

The paper that Johnson cites is, in my opinion, overly simplistic.

Shareholders can compensate executives partly by using restricted stock (stock that cannot be sold for a period of time) and stock options that vest gradually. These mechanisms provide some incentive for executives to focus on long-term franchise value. However, short of making banks into partnerships, there is no way to force executives to hold onto their stock forever.

Once they are able to sell their stock, you would expect bank executives to sell. They want to diversify their holdings as much as possible. Moreover, it is dangerous for bank executives to buy their own stock, both financially and legally. (Legally, frequent trading in their own stock would subject them to all sorts of potential hazards. As it is, even sale of stock has to be done carefully, to avoid insider trading issues.)

The authors' sample period of 2000-2008 seems rather long relative to the point they are making. If the bank executives were truly knaves, they would have bought stock in the early part of the sample period and sold it in the latter part of the sample period. Or at least they would have arranged to have a larger share of their compensation in stock in the earlier period and a smaller share in the later period.

Look, am I a fan of bank executives? Not at all. Do I think that bank executives should enjoy limited liability? No, I have often written that I think they should face the possibility of prison if their institutions fail.

However, if you want to convince me that bank executives were more knaves than fools, then you need to come up with a more solid study than this one.

Comments and Sharing

COMMENTS (7 to date)
J Oxman writes:

If the bank executives were selling in such (apparently) huge quantities, why was this not interpreted as a negative signal by the market? Indeed, because it was likely expected behavior, for the reasons you (Arnold) illustrate above. As shares vest, we expect executives (of banks and non-banks) to diversify, since they are likely not risk-loving people.

Doug writes:

In the summer of 2008 I was interning as a quant in fixed income at a major investment bank... in the risk management group for fixed income derivatives. I will say this much:

1) No one in either risk management, fixed income research or the trading desks perceived a large risk in the massive correlation and skew risk that were on our books.
2) In fact no one even thought that the size of these risks were that particularly large (the VaR based on our (highly computerized) models seemed appropriately low for the banks capital).
3) The biggest concern at the time with the CDOs and CDO^2s in inventory was interest rate risk.
4) Most people who shorted the company did so for hedging reasons, not for speculation reasons.
5) Traders' sentiments were bearish on the company as a whole, but overwhelmingly this sentiment was due to the perception that the firm wasn't being aggressive and risk-taking enough, rather than overly risky.
6) At the time risk management's biggest fear for financial meltdown was Goldman Sachs, which ended up being the only bank to make money in 2008.
7) Even when the meltdown started in early August everyone even then drastically underestimated the magnitude. In fact a week after the structured credit market collapsed the CEO gave a speech saying how fixed income trading was now the future of the company and primary driver of growth.

steve writes:

Thanks Doug. I have always preferred the fools narrative more than the knave argument. Much better to have our finance system run by idiots than crooks.


Mike writes:

Like Steve, I'd like to thank Doug.

The real action in a study like the one Johnson writes about would be right below the level of management that gets "serious" stock option compensation. Although that might not really provide any insight since insider trading has been defined so broadly, many employees likely avoid their own stock.

Foobarista writes:

A better test would be to compare these execs with similarly-compensated execs from other industries (such as technology).

Henry Milner writes:

Malmendier and Tate (2003) use excessive holding of company stock by executives as a proxy for overconfidence. They find that many executives hold their stocks and options for too long, and that on average the executives lose money because of this. Of course, that's not ironclad proof that there's no malfeasance, but it's interesting that the intuition runs in completely opposite directions.

Jack Tatom writes:

These comments ignore direct payment of executives in stock grants, again usually limited by a minimum holding period. All stock received as compensation is "purchased" by the executive in the form of reduced cash compensation. This is completely ignored in the study cited by Johnson. It is a virtual certainty that the sales the study measures are far smaller than these purchases, so their conclusion about sales and purchases is completely backwards.

And why should the executives make direct cash purchases of stock? They tend to have a serious problem of reducing their stock holding to have a balanced portfolio. The underlying premise that executives should hold disproportionate shares of their company stock is contrary to what most planning experts tell employees about their 401k investment holdings, especially post-Enron.

So the evidence in the Bhagat and Bolton paper are consistent with rational executives that are constrained to hold a share of company stock that may even exceed the company's share of global market capitalization. Even taken at face value, i.e. ignoring their massive indirect purchases, the study does not show that executives are exercising incentives for excessive risk taking, contrary to the claims of Bhagat, Bolton and Simon Johnson.

Comments for this entry have been closed
Return to top