Bankers' Compensation and Prudential Supervision

This is a Chapter contributing to the Research Handbook on Executive Compensation. In the quest for possible causes of the recent financial crisis, commentators often argue that bank executives had poor incentives. Critics claim, in particular, that executive compensation was not properly aligned with long-term performance, while regulators seek ways to change practices in order to restore this alignment. At least two questions arise with respect to incentive practices. The first is whether executive compensation at banks before the crisis was predominantly short-term oriented. Academics and politicians answer this question differently. The latter argue, with the support of the media, that widespread short-term incentives to bank managers were at the root of the recent crisis. On the academic side of the current debate, recent empirical studies reveal no proof that short-term incentives led to excessive risks. The second question is whether banking regulation should cover compensation arrangements, either by mandating pay structures or by requiring their adjustment in order to avoid excessive risk taking. I submit that regulators should not replace boards in setting pay structures and that regulatory intervention concerning executive pay at banks should be limited in scope, so as to maintain the flexibility of executive pay arrangements. I examine the Principles for Sound Compensation Practices and their Implementation Standards issued in 2009 by the FSB and critically assess the same in light of the preceding discussion. The Chapter concludes with some remarks on the case for regulating bankers' pay