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(originally published by Booz & Company)


Short-term Compensation and Banking Failure

If the trading levels before the crisis had been normal, the researchers said, it would have implied that the CEOs did not know that serious trouble was looming. In that case, the executives could have been seen as diligently working in tandem with the interests of their long-term shareholders and as being taken by surprise by “unforeseen risks” in investments and trading strategies that plunged the institutions into crisis.

The researchers recommend that executive incentive compensation consist almost entirely of restricted stock and options, meaning CEOs would not be able to sell the bulk of their holdings for two to four years after their last day on the job. To offset concerns over liquidity, the authors suggest that CEOs be allowed to sell a small amount of stock each year, at a capped dollar value. This structure would provide the CEOs with more incentives to look at the long term and avoid short-term risks, the authors conclude.

Bottom Line:
An analysis of the 14 largest U.S. financial institutions in the eight years leading up to the recent economic crisis shows that top executives sold an unusually high amount of their company stock. The highest levels of stock sale came from banks that failed — specifically Lehman Brothers, Countrywide Financial, and Bear Stearns. The researchers raise the question of whether executive compensation should be structured to provide less incentive for making risky decisions oriented to short-term gains.

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