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Bhagat, Sanjai; Romano, Roberta --- "Reforming Financial Executives’ Compensation for the Long Term" [2012] ELECD 605; in Thomas, S. Randall; Hill, G. Jennifer (eds), "Research Handbook on Executive Pay" (Edward Elgar Publishing, 2012)

Book Title: Research Handbook on Executive Pay

Editor(s): Thomas, S. Randall; Hill, G. Jennifer

Publisher: Edward Elgar Publishing

ISBN (hard cover): 9781849803960

Section: Chapter 7

Section Title: Reforming Financial Executives’ Compensation for the Long Term

Author(s): Bhagat, Sanjai; Romano, Roberta

Number of pages: 23

Extract:

7 Reforming financial executives' compensation for
the long term
Sanjai Bhagat and Roberta Romano*


1 INTRODUCTION

A myriad of factors have been identified as contributing to the ongoing global financial
crisis, running the gamut from misguided government policies to an absence of market
discipline of financial institutions that had inadequate or flawed risk-monitoring and
incentive systems.1 Such government policies include low interest rates by the Federal
Reserve and promotion of subprime risk-taking by government-sponsored entities domi-
nating the residential mortgage market so as to increase home ownership by those who
could not otherwise afford it, which fueled a housing bubble, and bank capital and insti-
tutional investor holding requirements dependent on credit ratings by entities which were
either conflicted or incompetent (or both), providing triple-A ratings to securitized pack-
ages of subprime mortgages. Identified sources of inadequate market discipline include
ownership restrictions, deposit insurance inducing moral hazard, ineffective prudential
regulation including capital requirements that favored securitized subprime loans over
more conventional assets, while internal organizational factors contributing to the crisis
include business strategies dependent on high leverage and short-term financing of long-
term assets, reliance on risk and valuation models with grossly unrealistic assumptions,
and poorly designed incentive compensation. This myriad of factors, taken as a whole,
encouraged what was, as can readily be observed with the benefit of hindsight, excessive
risk-taking.
Yet only one of the items on the long laundry list of factors contributing to the crisis
has consistently been a ...