Executive Compensation at Financial Institutions
One of the more interesting provisions in the realm of executive compensation is the disclosure and prohibition of “risky” incentive-based compensation. Section 956 mandates that Federal regulators must (1) require covered financial institutions to report the structures of all incentive-based compensation arrangements and (2) prohibit incentive based payment arrangements that encourage inappropriate risks by providing employees, directors or principal shareholders with excessive compensation or that could lead to “material financial loss” to the covered financial institution. Notably, §956 covers only financial companies and excludes from its requirements any institution with assets less than $1,000,000,000.
Taken together, it is abundantly clear what the drafters of this section were trying to accomplish. It is no secret that one of the main components of the recent financial crisis was a result of financial institutions taking risky bets on certain collateralized debt obligations – notably, mortgage-backed securities. In doing so, these large financial companies increased their risk profile(s) far beyond what is deemed to be acceptable, in hindsight. When the risky bets didn’t pay off, a number of large banks (like Lehman, for example) collapsed under the weight of their own bad, and risky, bets. Accordingly, taxpayer dollars were used to prop-up these massive and failing institutions (via the Troubled Asset Relief Program) because they had been deemed “too big to fail”. This is the crux of section 956.
First, by limiting the applicability of this provision to only financial institutions with assets over 1 billion dollars, the drafters made clear that they were targeting “large banks only” – the same culprits who benefited from the TARP bailout funds. Secondly, in a perverse misdiagnosis, this provision focuses on “incentive-based” compensation as a means of reducing the kind of company-wide risk that created mortgage-backed securities disaster. The apparent theory behind this is, if incentive based compensation is prohibited, then financial company executives will be less-inclined to take large risks with their companies’ positions – thus created a safeguard against “material failure”. This is a misdiagnosis for a number of reasons. First, to assume that the bulk of these risky positions taken by financial companies were correlative to the incentive-based compensation is inaccurate. While it may be true that the same underlying forces drove the decision to take excessive risk (greed, competition, etc.) it is an oversimplification to attribute this excessive risk-taking to individual executive compensation structure. While it is true that a number of executives made a lot of incentivized money in the years before the crash, it is not appropriate to equate those gains with the cause.
Furthermore, they are doing a bigger disservice to the shareholders of these financial companies by eliminating such incentive-based compensation plans. That is, in a lot of ways, risk is a good thing – and if you have salaried executives, they may become highly risk-averse (which is not necessarily a good thing when we are trying to climb our way out of a recession). By extension, if you continue to apply the logic of this “anti-incentive” section of the Dodd-Frank bill, you aim the economic ship right back toward the days of the 3-6-3-3 rule; thus eliminating these financial companies from a globally-competitive position. Is that really consumer protection?
While this section does provide a caveat by insisting that, in establishing standards for incentive-based compensation prohibitions, Federal regulators must ensure that the standards are comparable to the standards established under the Federal Deposit Insurance Act, they also leave the language dangerously vague. The language dictates that regulators may prohibit “any such arrangement that the regulators determine encourages inappropriate risks”. This is far too broadly constructed to be effective and could likely create a negative deterrent effect on the performance of certain financial institutions and the level of talent they are capable of drawing.