Commentary by David F. Larcker, James Irvin Miller Professor of Accounting & Director, Stanford GSB Corporate Governance Research Program; and Brian Tayan, Stanford GSB Case Writer, MBA ’03.
Did high banker pay cause the financial crisis of 2008 and 2009? Josef Ackermann, chief executive officer of Deutsche Bank, does not seem to think so. In a recent Bloomberg article titled “Ackermann Says High Pay at Banks Didn’t Cause Losses (Update1)” published on 2-19-2010, Ackermann was cited as saying “Is there a correlation between the compensation system and losses? Yes, but it’s negative.” He pointed out that German financial institutions with higher levels of executive compensation were less likely to require aid from the government, whereas those with lower levels (including state-owned banks) were more likely to.
It has become common consensus among the press that compensation either caused or contributed to the crisis. The nature of this relationship, however, is by no means clear. Although the topic is too extensive to be dealt with here, we should point out some important points:
1) There is a difference between inappropriate pay levels and inappropriate pay structure. It is likely that any relation between compensation and the crisis had more to do with the latter (i.e., cash and equity bonuses that lacked deferred payouts, clawbacks, or hold-to-retirement provisions).
2) Most of the companies that created the structure products that led to the crisis believed in their value enough to retain exposure on the balance sheet. The incentive value of compensation only works to the extent that the management and the board understand the risks they are dealing with. In this case, most did not. A change in pay structure therefore might still have led to the same outcome (the difference being that the CEOs would have actually suffered along with shareholders).
3) Compensation is a complex issue that will not be fixed by mandating a one-size-fits-all solution. For example, a recent working paper by Armstrong, Larcker, and Su (2010) finds that wealth effects are an important contributor to the incentive value of compensation. Any serious reform to compensation will likely have to take place at the company-specific level where individual circumstances can be addressed, rather than at the regulatory level where they would apply equally to all companies. (Paper source: Endogenous Selection and Moral Hazard in Executive Compensation Contracts found on SSRN.)
While Ackermann makes interesting points, in all likelihood he is just as far off the mark as his critics are.