Should U.S. Government Regulate the Compensation of Senior Bank Executives?

The agency problems are prevalent in most commercial banks and play an important role because of many reasons, among which are the specifics of bank operations and capital structure, high leverage, easily manipulated accounting measures and weak market of corporate control. Banks commonly use incentive compensation as the main tool to prevent such problems, which became a crucial mechanism of corporate governance.   Today relatively high compensation of U.S. bank CEOs and its sensitivity to bank’s performance is debated in government and financial press. Critics of performance-based pay argue that excessive risk-taking caused by alignment of interests of top managers with those of shareholders, timing of bonuses and equity option grants have contributed a lot to recent crisis, affected banks’ performance, and initiated social concerns. They also suggest that stricter regulation of top manager’s compensation should be adopted. However, intervention of government authorities in designing CEOs’ compensation may not necessarily be effective, because banks may better understand their internal problems, risk and other characteristics that determine optimal compensation schemes. As governments play a role of monitoring, it is important to understand if this monitoring substitutes or complements other mechanisms of corporate governance in banks. For instance, John and Qian (2003) suggest that by understanding the interaction of regulation and corporate governance, it is possible to gain insight into the optimal design and degree of regulation by governments. Although today’s issues in banking industry has raised the question of compensation regulation, too much intervention by government cannot actually solve the problem of excessive risk taking entirely, because banks, for example, may find another ways to avoid the law in order to attract valuable employees. Furthermore, regulation can at some point exacerbate agency problems and other issues in banks.   The present essay...