In a last-minute addition to the stimulus bill
passed Friday, Congress imposed tight restrictions on pay arrangements in
all financial firms that have or will receive funds from the federal
government's Troubled Asset Relief Program (TARP).
While I have long been a critic of corporate
compensation practices, these restrictions leave me concerned. They weaken
executives' incentives to deliver the long-term performance that is needed
to benefit banks, the economy, and taxpayers who have injected vast
amounts of capital into these institutions.
While the new restrictions seem to have
been motivated by a desire to limit total pay, it is the pay structure
that they tightly regulate. The Obama administration's proposals focused
on constraining pay unrelated to performance. The stimulus bill takes the
opposite approach -- constraining incentive compensation, limiting it to
one-third of total pay.
To be sure, incentive compensation in many
public companies has been flawed. Some incentive compensation has been so
in name only, and some of it has provided perverse incentives to focus on
short-term results to the detriment of long-term performance.
But these problems require tightening the
link between pay and long-term performance -- not giving up on it
altogether. Mandating that at least two-thirds of an executive's total pay
be decoupled from performance, as the stimulus bill does, is a step in the
Another wrong step is the bill's
categorical prohibition on using any form of incentive compensation other
than restricted stock. In the first place, some executives covered by the
bill (up to 25 in some firms) run limited parts of the company's
operations. Their incentive pay might be best tied to the performance of
their unit's particular results, not to that of the whole company.
But even for top executives, the banks'
special circumstances may make exclusive use of restricted stock contrary
to taxpayer interests. In many banks, the shareholders' equity, which is
junior to the government's investments in preferred shares and the claims
of bondholders, now represents a small fraction of the bank's capital.
Indeed, the value of some banks' common shares might largely represent an
"out-of-the-money option," expected to deliver value only if things
In such circumstances, restricted stock may
provide incentives for executives to take excessive risks with the bank's
survival. Consider the case where an infusion of additional capital would
greatly dilute the value of common shares but would be best for the bank,
while failing to get that capital would put the bank's future at risk. In
such circumstances, compensation in restricted common shares would provide
executives with an incentive to avoid raising capital (which would wipe
out their shares' value) and gamble on survival without additional
The compensation restrictions have another
adverse effect on incentives. Executives can sidestep them by returning
TARP funds and avoiding them in the future. Some observers argue that such
actions would be unlikely because they would be costly to the bank. This
overlooks the divergence between the interests of the bank and its
executives. The bill provides executives with counterproductive and
unnecessary private incentives to terminate or avoid TARP funding, even
when doing so would not be in the bank's best interest.
The stimulus bill's adverse incentives
deserve special attention because of the government's current approach to
the banking sector. While infusing large amounts of capital into banks,
the government has chosen to leave their management largely to the
discretion of bank executives. This makes executive incentives of
Compensation structures with distorted
incentives may have already imposed large losses on investors and the
economy. Public officials should be wary of introducing new distortions
and perverse incentives. With so much hanging in the balance, ensuring
that those running the country's banks have the right incentives is as
important as ever.
Mr. Bebchuk, director of the
Harvard Law School program on corporate governance, is co-author of "Pay
without Performance: The Unfulfilled Promise of Executive Compensation"
(Harvard University Press, 2004).