A Pay Plan to Make Bank CEOs Think of the Long-Term

The pay of bank chief executives should be linked in a substantial way to the long-term performance of their banks.

Such linkage could be an important supplement to improved monitoring in a reformed deposit insurance system for commercial banking.

Monitoring Capital

Late-stage diligence in monitoring of asset value is universaly advocated.

Operations of banks that hold serious amounts in delinquent loans are to be halted unless capital can be raised to an adequate ratio to real assets.

This diligent monitoring of the capital ratio stresses the marking down of all delinquent assets from nominal to approximate market value.

Monitoring Risk

Intermediate-stage monitoring of the risk rating of bank assets has also been strongly advocated, though less widely. Different insurance premiums might be assessed on the basis of asset risk categories.

Basing premiums on risk would be an attempt to reduce the number of bank failures by deterring banks from choosing high-risk asset structures.

It is difficult, however, to develop standards for measuring a bank's soundness in order to assign different premiums.

Let us grant that experience in risk rating and premium pricing would eventually make a modest contribution to deposit insurance regulation.

Still, strong incentives for bank self-monitoring should be introduced - motives for executives to use optimal prudence in acquiring assets.

Compensation that Motivates

Suppose that tying a substantial part of a chief executive's compensation to long-term performance were a requirement for government deposit insurance.

Regulatory monitoring would be needed only to deep the self-monitoring going and to ferret out subterfuges.

Intermediate-stage monitoring for risk could be downgraded.

For industrial corporations, such compensation is being increasingly advocated as a way to increase innovation and productivity.

It rewards managers who make expenditures that have a real chance of creating value in the distant future.

Furthermore, executives who bet in this way on their companies' future encourage investors to be patient about company spending that forgoes present earnings for future benefits.

In turn, management is implicitly assured sufficient tenure, regardless of immediate earnings and stock prices, to participate in the future rewards.

Building Trust

Trust is thus built between the owners of capital and the managers, who are indirectly motivated to match or beat the longterm orientation of the Germans and Japanese.

In banks, requiring such a compensation feature would similarly build trust between owners of bank capital and the managers.

Bank managers would be inderectly motivated to reduce their drains on the reserve pool of government-guaranteed deposit insurance and on the taxpayer through additional bailouts.

A 50% Deferral

Here is how the plan might be implemented:

* Any bank granted entitlement to deposit insurance would be required to withhold annually, for example, 50% of its chief executive's compensation for five years.

* The deferred reward would be calculated on the basisof performance relative to some agreed-upon target - say, discounted flows of dividends plus net-worth changes after capital costs per share.

The final payout could be a multiple, a fraction, or even a negative fraction - a debit against succeeding deferrals - of the compensation withheld, compounded over time.

Rewarding Prudence

Such a system would properly reward bank management for declining high-yield loans - despite the immediate contribution to reported profit - if they seem susceptible to long-term deterioration.

Deferred compensation for bank management would also reassure uninsured depositors and the insurer-regulator.

The regulator would be largely freed of the almost hopeless job of micromonitoring - of seeking early warning signs of risk among a bank's longer, more complex loans.

True, some good might come from imposing different insurance premiums according to broadly defined risk categories in a bank's assets. But the providers of government deposit insurance would do better to husband the insurance the insurance fund and motivate bank executives through the compensation plan described here.

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