Executive Compensation in Banks - Literature review Example

Executive Compensation in Banks Deregulation in banks can be traced back in 1980 when Depository s Deregulation and Monetary Control Act was enacted in the United States. This allowed the banking institutions to engage in risky commercial loans and investments. Following the deregulation, the regulation of the compensation of bank and financial institution employees has also been out-grasped to allow competitiveness within the industry and against the non-banking institutions. Hence, high compensations including bonus and incentives have been implemented by the banks as implemented by the bank executives. Deregulation was expected to affect financial performance and risk of the banking institutions (Mahon and Murray, 1981). The primary purpose of the deregulation is to allow competitiveness among the banks competitive by enlarging the range of allowed contracts. However, the flawed executive compensation schemes have been blamed for the unexpected failure of several banking institutions. Such deregulation allowed banking institutions merge with other banks. 3 academic journals have been included by this writer in this essay to show the studies conducted in proving that the flawed structure of compensation have led to the collapse of many banking institutions. It can be inferred from those papers that the writers are pointing to the said flawed structure as one of the leading causes of the banks’ failure. The 3 academic journals reviewed are the following: 1) CEO Compensation and the Transformation of Banking by Maretno Harjoto of San Jose State University and Donald Mullineaux of the University of Kentucky; 2) Bank Executive Compensation and Income Management by William Joyce; 3) Bank CEO Pay-Performance Relations and the Effects of Deregulation written by Anthony J. Crawford of University of Montana, John R. Ezzell and James A. Miles who are both from Pennsylvania State University. The writer would like to delve on the takes of the above cited writers which could probably be the factors that caused the downfall of many of the banks in the United States. The first academic paper was written by Harjoto and Mullineaux (2003). Their paper was entitled CEO Compensation and the Transforming of Banking. In the said paper, it was revealed that the incomparable high compensation of bank executives is mostly attributed to the passage of law on deregulation and the signing of the then U.S. President Clinton of the Gramm-Leach-Bliley Financial Modernization Act in the 1990s which revoked the restriction against the merger of commercial and investment banks, many commercial banks were pressured to adopt compensation policies of investment banks which provide higher compensation than the former banks. The paper written by Harjoto and Mullineaux (2003) focused on the difference between the compensation of investment banks and commercial banks, particularly in the entry of bank holding companies (BHC) to investment banking which influenced the equity based incentive component of CEO compensation. There was a significant increase on the part of the BHCs in the 1990s not only because of the technological innovations but primarily because of the changes in the legal environment particularly the said passage of deregulation law. Along with it was the growing competition within and outside the banking industry. CEO’s compensation at commercial BHCs consists of salary, bonus and equity-based incentive pay. Before the deregulation, banks do not normally engage in incentive-based compensation since the banking industry used to be regulated. The value of the manager’s decision making abilities has increased when the amount of growth options have increased. There are two views which determined the CEO’s compensation. As postulated by Murphy (1998), the first is mostly by the length of tenure of the CEO and by his or her probable influence over the board of directors which establishes the CEO’s salary. The second argument avers that managers acquire increased firm-specific human capital and a better reputation as tenure increases. This should result in higher compensation of the CEO. On the other hand, there are also some factors that influence the compensation of the managers such as: (1) leverage (observable risk); (2) market –to-book ratio of assets; (3) asset size; and (4) the returns generated for shareholders. The managers usually demand higher compensation when they are faced against risky activities. There is even a rumor that banks increased the risks by maximizing the put option value of deposit insurance because of the higher compensation given to the executives. Nonetheless, there was no concrete proof to substantiate this claim. The second paper reviewed was the “Bank Executive Compensation and Income Management” written by William B. Joyce (2002). To compare with the first academic journal, in Joyce’s study, the flawed system in compensation and the discretionary power of the managers and executives have been pointed by the author. Unlike the first paper, the author pointed the flaws to different factors that influence the banks to give higher compensation. Negative implications have resulted because of the scheme or system of giving bonus to bring into line the short term objectives of the executives and shareholders. He gave some examples where the said flaw lies. Since there is no clear provisions for loan losses (annual) PLLA, executives are taking advantage of the incentive schemes to maximize total monetary compensation. The loan-loss reserve is subject to significant management discretion. This area is used by the bank executives to manipulate earnings. It has been seen that bank executives can exercise discretion over loan-loss provisions. It can be used to maximize the compensations that the executives of the banks can earn. Hence, banks may have discrepancies with regard to their actual holding reserves and the best estimates of losses that they should be limiting based on their loan portfolios. This poses a problem for every bank. Therefore, the management of income of the banks can be manipulated such as by reducing income fluctuations (smooth income), maintaining capital requirement and minimizing tax payments to maximize the probable compensation to be earned. For example, if the income is already way beyond the target for the current month, the income will be purposely suppressed or intentionally lessened until the next month to anticipate possible low earnings and cover this to reverse the issue. And if the income or achievement is below the target or quota for the given month, the bank executives will try to make it more badly so that in the following or succeeding year, the amount earned can easily be reached as if there was a seemingly drastic improvement. In such case, the improvement in terms of income will be credited to the new manager / officer. In income-smooth scheme, the executives manage the income so as to prevent the fluctuations of the bank’s income and manage the future incomes. Usually, the CEOs of the non-performing banks are inflating the incomes of the banks to cover up their shortcomings and to maintain and boost their profit-based bonuses and to protect themselves to retain their positions. On the other hand, CEOs who are transferred to replace non-performing CEOs manipulate the earnings on their early incumbency in the position so that the poor performance of their predecessors is highlighted and later on put up some good numbers to show the turn-around in their terms. As these things are not transparent, the stockholders of course are not aware of these manipulations. The turnover of the executives, therefore, contribute to the timing of loan-loss reserves. The aspect that is usually manipulated is the figures from loan-loss reserves. PLLA is normally used to smooth income. Having the discretion, bank executives can maneuver the timing of the transactions to manage the cash flows. Bank executives may employ different cases from loan reserves to maintain the required capitalization. Managing and manipulating the loan reserves affect the capitalization of the banks. From this. we can now see the connection between the maintenance of adequate capital through the maintenance of loan reserves. On the aspect of minimizing the tax payments, bank executives normally plan the timing and flow of the transactions to control the taxes to be paid. In doing so, the flow of loan-loss provisions is also considered. Everything will still be according to the plan of the CEO’s or the executive officers. As the tax payments are minimize, better incentive or bonus can then be passed to them. Given the said efforts made by the bank executives to manipulate the accounting earnings, naturally, all the previous exercise of discretions is pointing to the attainment of highest possible monetary compensation. The banks placed systems wherein when the agency costs are reduced, the employees particularly the bank executives are given more incentives. As the incentive schemes are not properly structured and monitored, the manipulation of income has become very rampant and a normal scenario for the bank executives in several banking institutions. Bonuses are as well within the contemplation of compensation together with salaries and stock options. Bonuses are usually based on earnings per share and growth in earnings per share. Earnings per share is said to be for short-term goal only, thus, is susceptible to manipulation. Bonus plans are most likely computed on the basis of the amount of the salary. Hence, then bigger the salary of the CEO, his or her bonus is also high. Stock-option plan is also part of the compensation but it has the emphasis of long term benefit for the executives. In this set-up, executives are given the privilege to purchase shares which come with special price within a specified period. Thus, Joyce (2002) posed three (3) hypotheses, namely: (1) the early compensation hypothesis; (2) the income-smoothing hypothesis; (3) the modified compensation hypothesis. As per early compensation hypothesis, executives put efforts to increase the banks’ income to generate more compensation for themselves. The income-smoothing hypothesis is employed by the executives to secure their positions within the banks. The modified compensation hypothesis pertains to the efforts done by the executives to increase and lower the bank’s current income to ensure consistently their current and future high compensation. The third paper evaluated was the study made by John E. Ezzel and James A. Miles (2001) “Bank CEO Pay – Performance Relations and the Effects of Deregulation.” As early as 1970s, there were already efforts to deregulate the banking industry. The kind of structures of executive compensations has been one of the reasons that affect the conflicting interest of the shareholders and the CEOs of the banks and this result to some principal - agent problems. The root cause of this is the deregulation that highly emerged during the 1900s. The authors in this study examined the effect of deregulation on the pay-performance sensitivity of the three components of the bank compensation of the CEOs and the banks’ performance. It also includes salary, bonus, stock options and stock ownership. Subsequent to the deregulation on the banking industry, the managerial discretion has also increased giving the CEOs more authority to invest in risk-return growth opportunities that used to be off-limits for them. Because of the deregulation, real growth opportunities expanded which is highly associated with stronger pay performance. Also, deregulation increased the possibility of risky non-positive investments that transfer wealth from Federal Deposit Insurance Corporation (FDIC) to the shareholders of the banks. The fixed premium insurance is said to be posing a moral hazard problem since the insured depositors cannot just monitor the risks entered into by the managers or CEOs because their investment is insured. Should the projects that are risky result into success, the stockholders are benefitting from it while the losses are limited to what little equity is there. The higher level of discretion given to the managers due to the deregulation brought bigger effect to the wealth of the shareholders. Having given more discretion, managers and CEOs of the banks can engage in investments that have higher risks. Lucky if the risk becomes a success, however, as high as it could reach, the same impact that it could pull down in case of failure. Although this study did not clearly dealt with the negative effect of the extent of power and discretion of the managers and CEOs of the banks, it has remained consistent with the fact that the enactment of the law on deregulation gave much leeway on the structures of compensations of the executives as well as their power to decide in behalf of the organization. The following are the methods used and the results obtained by the three academic journals: 1) The study of Harjoto and Mullineaux (2003) obtained the data as sample from Standard & Poor’s Execucomp database which contains compensation data from 1992-2000. Cross-sectional, time series analysis that allows for increase degrees of freedom and more efficient estimates has been employed by the writers. Another notable factor that influences banks to give higher compensation is the availability of the growth options. BHCs entry to investment banking has increased the growth options, which include necessarily higher or bigger risks which in turn prompt the banks to grant higher compensations to their executives. The hypothesis on the study made by Harjoto and Mullieneaux (2003) confirmed that the executives of firms with more volatile stock prices have less performance-based compensation. CEO’s compensation might also be influenced by some characteristics of the board of directors such as when the CEO is also the chair of the said board. Being the chair of the board, he can exercise his or her influence over the other members of the board and diminish the independence of the other members. As such, the compensation of the CEO might be set higher in this case due to weak corporate governance. Risk-averse CEOs or those who wanted to take risks only if they are compensated for it may have plans and goals that are adverse or in conflict with those of their shareholders. There may be an agency problem in this case. The data of the said study shows that there are substantial differences in the total average in the compensation between the investment banks and the commercial banks. i.e. The total average compensation at investment banks ($5.5 million) is larger than those of the commercial bank ($3.1 million) which has significant difference at 1% level. This is where the higher risk factor comes in wherein executives and CEOs tend to ask and demand for a higher compensation when they have faced with higher risk challenges. In relation to it, the commercial banks are seemed to be inclined in giving incentive- related pay compared to some investment banks. This only shows that commercial banks want to see more profits first before giving additional compensation as rewards which is not in the case of investment banks. Moreover, it has been found that investment banks give more bonuses compared to other banks and it has also been seen that salary is still the smallest compensation which clarify that a big part of the compensation is coming from the bonuses and others. The fact that investment banks have more growth options than commercial banks shows that investment banks are more generous in giving higher compensation to its executives. The tenures of the CEO’s in investment banks appear to be longer compared to other banks. Consequently, this has an effect in the observation that CEO’s of investment banks have higher compensation (including bonus) as preeminently, tenure influences the amount of compensation. Also, as incentive banks are more exposed to risks, pay-for-performance sensitivities are found to be significantly larger for the incentive component of the compensation. When banks were allowed to enter high risk activities, banks tried to obtain officers and managers that are highly qualified and to lure the better qualified individuals, higher compensation should be offered and laid down on the table. 2) The Joyce (2002) employed Regression equation using the COMPUSTAT data file from various banks. Although the computation using the regression equation revealed that the high compensation of the bank executives primarily come from their stock holdings, it is still safe to infer that the long tenures of the executives included in the data have something to do with the results as they may have exercised their options in the past. Executives who have stock options tend to be less concerned with the earnings of the banks and more inclined to side with the conservative accounting. On the case of bonuses, it was confirmed based on the computation that executives might be decreasing the income if the income is already above the target, so as to spread the entry of the possibility of consistency in getting high bonuses. This is congruent with the hypotheses of income-smoothing and bonus maximization. The author gave his recommendation that banks should have more rigid accounting standards to lessen the manipulation of income. The auditing standards should likewise be modified so that it would be more responsive to the issues at hand. 3) The authors used the data from 1982 and 1988 when significant deregulation took place. Salary and bonus data were gathered 239 CEOs of 124 banks. The relation of pay-performance sensitivity in the executive pay and the performance of the banks are measured using the regression model. Interestingly, the result was different from the two prior papers reviewed. The study found that after the deregulation, there was a dramatic increase in the relationship between CEO pay and the bank’s performance. The data shows that after deregulation, there were 3 2¢ increase in CEO salary and bonus for every $1,000 increase in the wealth of the shareholders. This is opposite in the pre-deregulation period wherein no relation was found between the CEO option wealth and bank performance. There was a strong relation between the salaries and bonuses of CEOs and the banks’ performance. The pay-performance sensitivity is expected to go higher as the CEOs role in the success of the banks is more seen. The last study has been in contrary to the first two studies as here, the grant of higher compensation has been significant in the good performance of the banks, safe enough to infer that the downfall of several banks was affected by it and the success of many banks is largely because of the competitive compensations and discretion given to the bank executives. The opinions of the academic authors or writers are different as the first two academic papers have attributed high compensation and more discretionary power as factors in the collapse of several banks in the Unites States. Hence, there was no consensus among the findings of the three academic journals. References Crawford, A., Ezzel, J., Miles, J. (2001). Bank CEO Pay-Performance Relations and the Effects of Deregulation, p. 231-256. Harjoto, M.A., Mullineaux, D.J. (2003). CEO compensation and the transformation of banking. The Journal of Financial Research, 26(3), 341-354. Joyce, W. (2002). Bank executive compensation and income management, Bank Accounting & Finance, 9-17. Mahon, J.F. and Murray E.A. (1980). Deregulation and strategic transformation, Journal of Contemporary Business, 9, 123-128. Read More