Cutting or regulating the paychecks of top executives won’t avert future economic crises and recessions because the source of corporate risk taking and fraud typically emerges from non-executive employees, according to a leading financial law expert at Cornell University.

Cornell Law Professor Charles K. Whitehead examined the relationship between executive compensation and bank risk in a newly published paper, “Risky Business: Competition, Compensation, and Risk-Taking,” and found little-to-no relationship between the regulation of top executive compensation and the risks taken by more junior executives.

Examples of risk-taking and losses by non-senior executives in the financial industry abound:
• Fabrice Tourre, a Goldman Sachs vice president, was found guilty of securities fraud Aug. 1 that caused three firms to lose $1 billion.
• Bruno Iksil, a JPMorgan Chase trader, caused losses of up to $6.2 billion that are still being calculated.
• Nick Leeson, a mid-level futures trader, incurred $1.3 billion in losses at Barings Bank, bringing about its collapse in the mid-1990s.

Whitehead’s paper describes the period leading up to the 2007 financial crisis and how non-executive incentives were determined largely by market demand for talent, rather than being set by individual bank managers.

“We often think of competition as benefiting the marketplace. It forces companies to keep prices low and quality high or, in the case of staffing, it helps in allocating the best employees to the most profitable firms. But competition can also have its costs,” Whitehead said.

Leading up to the financial crisis, competition diluted bank managers’ ability to set non-executive pay and contributed to the rise in risk-taking across the banking industry. Competition dominated the size of employees’ paychecks, failing to curb some non-executives who took significant risks that enhanced short-term performance and then moved on to new jobs before any losses materialized.

Whitehead’s paper argues for three regulatory changes.

  • First, in assessing how bank employees are paid, regulators need to compare how similar employees are paid by hedge funds, investment banks and others who compete with banks for talent.
  • Second, to lower incentives for employees to take risks and switch jobs, bank non-executives should be restricted from moving to other financial employers for a period of time after leaving the bank.
  • Finally, employers should be restricted from compensating new hires for that portion of the compensation received from a prior employer that was tied to long-term performance.

A copy of Whitehead’s paper “Risky Business: Competition, Compensation, and Risk-Taking,” is available online.

Source: Cornell University