Regulating bankers' pay

Georgetown Law Journal

Volumn 98, Issue 2, 2010, Pages 247-287

  Bebchuk, Lucian A ^a   Spamann, Holger ^a  

^a HARVARD LAW SCHOOL   (United States)

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EID: 77949307533     PISSN: 00168092     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (146)

1. See, e.g., Press Release, U.S. Dep't of the Treasury, Statement by Treasury Secretary Tim Geithner on Compensation (June 10, 2009), available at http://www.ustreas.gov/press/releases/tg163.htm (stating that "compensation should be structured to account for the time horizon of risks").
2. See, e.g., LUCIAN BEBCHUK & JESSE FRIED, PAY WITHOUT PERFORMANCE (2004);
3. Lucian Arye Bebchuk & Jesse M. Fried, Executive Compensation as an Agency Problem, 17 J. ECON. PERSP. 71 (2003);
4. Lucian Arye Bebchuk et al., Managerial Power and Rent Extraction in the Design of Executive Compensation, 69 U. CHI. L. REV. 751 (2002);
5. Lucian Arye Bebchuk & Jesse M. Fried, Pay Without Performance: Overview of the Issues, 17 J. APPLIED CORP. FIN. 8 (2005).
6. See, e.g., Lloyd Blankfein, Do Not Destroy the Essential Catalyst of Risk, FIN. TIMES, Feb. 2009, at 7 ("An individual's performance should be evaluated over time so as to avoid excessive risk-taking. To ensure this, all equity awards need to be subject to future delivery and/or deferred exercise. Senior executive officers should be required to retain most of the equity they receive at least until they retire, while equity delivery schedules should continue to apply after the individual has left the firm.").
7. For a detailed analysis of how pay arrangements should be designed to address the short-horizons problem, see Lucian A. Bebchuk & Jesse Fried, Paying for Long-Term Performance (September 10, 2009) (unpublished manuscript, on file with authors).
8. Emergency Economic Stabilization Act of 2008, Pub. L. No. 110-343, § 111(b), 122 Stat. 3765, 3776-77 (codified as amended at 12 U.S.C. § 5221 (Supp. 2009)).
9. See American Recovery and Reinvestment Act of 2009, Pub. L. No. 111-5, § 7001, 123 Stat. 115, 516-20 (2009) (codified as amended at 12 U.S.C. § 5221).
10. See, e.g., Press Release, U.S. Dep't of the Treasury, Treasury Announces New Restrictions on Executive Compensation (Feb. 4, 2009), available at http://www.ustreas.gov/press/releases/tg15.htm.
11. See BASEL COMM. ON BANKING SUPERVISION, ENHANCEMENTS TO THE BASEL II FRAMEWORK 25-27 (2009);
12. LEADERS' STATEMENT: THE PITTSBURGH SUMMIT 2 (2008), available at http://www.pittsburghsummit.gov/ mediacenter/129639.htm.
13. See infra notes 67-80 and accompanying text.
14. Lucian A. Bebchuk & Holger Spamann, Regulating Bankers' Pay (Harvard John M. Olin Discussion Paper No. 641, 2009), available at http://ssrn.com/abstract=1410072.
15. See FIN. SERVS. AUTH., REFORMING REMUNERATION PRACTICES IN FINANCIAL SERVICES app. 1 (2009), available at http://www.fsa.gov.uk/pubs/policy/ps09-15.pdf.
16. See Corporate and Financial Institution Compensation Fairness Act of 2009, H.R. 3269, 111th Cong. (as passed by House, July 31, 2009).
17. In the House committee hearing on compensation structures and systemic risk preceding the passage of this bill, one of us argued, on the basis of our discussion paper, see Bebchuk & Spamann, supra note 9, in favor of including such provisions. See Compensation Structure and Systemic Risk: Hearing Before the H. Comm. on Fin. Serv., 111th Cong. (2009) (written testimony submitted by Lucian A. Bebchuk, Professor, Harvard Law School), available at http://www.house.gov/apps/list/hearing/financialsvcs-dem/ bebchuk.pdf.
18. Bd. of Governors of the Fed. Reserve Sys., Proposed Guidance on Sound Incentive Compensation Practices, 74 Fed. Reg. 55,227 (Oct. 27, 2009) (Docket No. OP-1374).
19. See, e.g., SWISS FIN. MKT. SUPERVISORY AUTH. FINMA, REMUNERATION SYSTEMS: MINIMUM STANDARDS FOR REMUNERATION SYSTEMS OF FINANCIAL INSTITUTIONS (2010) (circular 2010/1), available at http://www.finma.ch/e/regulierung/Documents/finma- rs-2010-01-e.pdf;
20. Guido Ferrarini & Maria Cristina Ungureanu, Reforming Compensation: The Latest Facts from Europe, PowerPoint Presentation (Sept. 17, 2009), available at http://www.ecgi.org/tcgd/2009/presentations/ungureanu.pdf.
21. See BD. OF GOVERNORS OF THE FED. RESERVE SYS., FEDERAL RESERVE PROPOSED INCENTIVE COMPENSATION GUIDANCE: QUESTIONS AND ANSWERS 1 (2009), available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20091022a2.pdf.
22. Partially financing assets (here, the bank's loan portfolio) with debt (here, deposits and bonds) provides "leverage" for the own funds invested (equity) because it amplifies the financial impact of changes in the assets' value; equity absorbs all the gains and losses on the assets even though it contributed only a fraction of the funds. In addition, with limited liability, "leverage" amplifies the asymmetry in the payoffs for equity. That is, while the possible upside is unlimited, limited liability caps the possible downside at the amount of the initial equity investment. For a recent review of moves toward regulating financial executives' pay in European countries, see the PowerPoint presentation authored by Guido Ferrarini and Maria Cristina Ungureanu, supra note 13.
23. See infra notes 67-80.
24. See, e.g., Lucian A. Bebchuk, Buying Troubled Assets, 26 YALE J. ON REG. 343 (2009);
25. John Coates & David Scharfstein, Lowering the Cost of Bank Recapitalization, 26 YALE J. ON REG. 373 (2009).
26. See, e.g., GROUP OF THIRTY, FINANCIAL REFORM - A FRAMEWORK FOR FINANCIAL STABILITY (2008);
27. Michael Solender, How the Obama Administration Should Regulate the Financial Sector, 26 YALE J. ON REG. 471 (2009);
28. Oliver Hart & Luigi Zingales, A New Capital Regulation for Large Financial Regulations 3-5 (Ctr. for Econ. Policy Research Discussion Paper, Paper No. DP7298, 2009), available at http://www.economics.harvard.edu/ faculty/hart/papers-hart.
29. Moral hazard in banks is a special, particularly severe case of moral hazard of equity in general. On the general problem of moral hazard, see Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. FIN. ECON. 305, 334-37 (1976). As we discuss at the end of this section, the moral hazard is particularly severe in banks because, by their very function, banks have extraordinarily dispersed creditors, namely small depositors, who have neither the incentive nor the competence to evaluate banks' risk-taking behavior or, more generally, their solvency.
30. See MATHIAS DEWATRIPONT & JEAN TIROLE, THE PRUDENTIAL REGULATION OF BANKS 6 (1994). Depositors certainly have no incentive to protect themselves when they are protected by deposit insurance.
31. See generally Gary Gorton & Andrew Winton, Financial Intermediation, in 1A HANDBOOK OF THE ECONOMICS OF FINANCE 432, 520-29 (George M. Constantinides et al. eds., 2003) (providing references to the abundant literature, including empirical literature, documenting the incidence of moral hazard at the bank level in the presence of deposit insurance). Cross-country evidence also supports the importance of deposit insurance for moral hazard.
32. See JAMES R. BARTH ET AL., RETHINKING BANK REGULATION - TILL ANGELS GOVERN 213-24 (2006) (finding, in a sample of over 150 countries, that deposit insurance increases the likelihood of banking crises);
33. Ash Demirgüç-Kunt & Enrica Detragiache, Does Deposit Insurance Increase Banking System Stability? An Empirical Investigation, 49 J. MONETARY ECON. 1373 (2002) (same for sixty-one countries);
34. Ash Demirgüç-Kunt & Harry Huizinga, Market Discipline and Deposit Insurance, 51 J. MONETARY ECON. 375 (2004) (finding, in a sample of thirty countries, that deposit insurance leads to greater risk-taking).
35. See, e.g., DEWATRIPONT & TIROLE, supra note 19, at 6; Gorton & Winton, supra note 19, at 520-29.
36. See DEWATRIPONT & TIROLE, supra note 19, at 29-45; TOMMASO PADOA-SCHIOPPA, REGULATING FINANCE - BALANCING FREEDOM AND RISK 7 (2004);
37. Dirk Heremans, Regulation of Banking and Financial Markets, in 3 ENCYCLOPEDIA OF LAW AND ECONOMICS 950, 954-56 (Boudewijn Bouckaert & Gerrit de Geest eds., 2000).
38. On other possible reasons for capital regulation, see RICHARD J. HERRING & ROBERT E. LITAN, FINANCIAL REGULATION IN THE GLOBAL ECONOMY 49-64 (1995);
39. Robert Charles Clark, The Soundness of Financial Intermediaries, 86 YALE L.J. 1, 10-26 (1976) (emphasizing the protection of small depositors as the main motivation for prudential regulation).
40. See BASEL COMM. ON BANKING SUPERVISION, INTERNATIONAL CONVERGENCE OF CAPITAL MEASUREMENT AND CAPITAL STANDARDS 16, 244 (2006).
41. On these capital standards generally, see, for example, MICHAEL P. MALLOY, PRINCIPLES OF BANK REGULATION 261-76 (2d ed. 2003).
42. See BANK OF AM. CORP., 2006 ANNUAL REPORT 61 tbl.11 (2007);
43. CITIGROUP INC., 2006 FINANCIALS & FORM 10-K 86 (2007);
44. JPMORGAN CHASE & CO., 2006 ANNUAL REPORT 130 (2007).
45. See CITIGROUP INC., supra note 23, at 2. In 2006, Citigroup earned 34% of its gross revenue from sources other than interest on loans, or 56% of net revenues (that is, revenues net of interest expense). Id. at 104.
46. For U.S. law, see PAULINE B. HELLER & MELANIE FEIN, FEDERAL BANK HOLDING COMPANY LAW § 5.07 (2009).
47. For the Basel rules and beyond, see Howell E. Jackson, Consolidated Capital Regulation for Financial Conglomerates, in CAPITAL ADEQUACY BEYOND BASEL: BANKING, SECURITIES, AND INSURANCE 123 (Hal S. Scott ed., 2005). Prior to Basel II, some countries pursued a different approach to the regulation of holding companies.
48. See Howell Edmunds Jackson, Regulation of Financial Holding Companies, in 3 THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND THE LAW 232, 234 (Peter Newman ed., 1998) [hereinafter Jackson, Regulation of Financial Holding Companies].
49. See Jackson, Regulation of Financial Holding Companies, supra note 25, at 233-34 (noting that this would not matter if the solvency regulation of the bank itself worked perfectly). In our numerical example, suppose that the 8% equity in the bank were held by a holding company, which was in turn financed by 50% equity and 50% debt (and, for simplicity, has no further assets). In this case, the first $4 paid by the bank to the holding company would accrue to the creditors of the holding company. If the assets of the bank fell below $96, the shareholders of the holding company would be wiped out and further losses would be of no concern to them. Shareholders, in other words, would discount any losses that exceed $4. To prevent this, banking regulation prohibits such additional leveraging at the holding level. This being said, bank holding companies were allowed to lever up more than banks because up to 15% (for "internationally active banking organizations") of their tier 1 capital could be contributed through "qualifying trust preferred securities," which, from the bank's point of view, is essentially long-term debt (default only occurs if the bank misses interest payments for at least five years). See 12 C.F.R. pt. 225 app. A.II.A.1.b.ii(3) (2009).
50. See BANK OF AM. CORP., supra note 23, at 148 (reporting $148 billion of debt at the holding level); CITIGROUP INC., supra note 23, at 12, 139-40 (reporting $116 billion of long-term loans at the holding company level, exclusive of $10 billion of junior subordinated notes relating to trust preferred securities, as well as at least $42 billion of short-term debt through Citigroup Funding Inc., which is guaranteed by the holding company).
51. See Jackson, Regulation of Financial Holding Companies, supra note 25, at 234-35.
52. In an empirical study, Howell Jackson found, in a sample of 175 thrifts in Arizona, California, and Nevada between 1986 and 1991, that those thrifts owned by holding companies were less likely to fail and, when they did, imposed less cost on the deposit insurer. Howell E. Jackson, The Superior Performance of Savings and Loan Associations with Substantial Holding Companies, 22 J. LEGAL STUD. 405, 416-19 (1993). But, he also found that the stand-alone thrifts were considerably smaller and younger than the integrated thrifts. Id. at 415. In any event, if there were beneficial effects of thrift holding companies present in Jackson's sample in the 1980s, they may not be present with the bank holding companies we are concerned with here because they are larger, and hence, themselves subject to the "too large to fail" moral hazard.
53. Even if the fund lost all its assets, creditors of the holding company could not touch any of the assets of the bank before the bank's own creditors, most importantly the depositors, were paid in full. On this essential role of corporate law for the partitioning of assets, see Henry Hansmann & Reinier Kraakman, The Essential Role of Organizational Law, 110 YALE L.J. 387 (2000).
54. An interesting corollary is that executives seeking to maximize the value of the bank holding company's common shares have an incentive not to diversify the sources of income the company derives from its bank subsidiaries on the one hand, and its other financial subsidiaries on the other.
55. See, e.g., HELLER & FEIN, supra note 25, ch. 4.
56. Empirically, non-interest, or fee based, income of financial holding companies is much more volatile than income from interest. See Robert De Young & Karin P. Roland, Product Mix and Earnings Volatility at Commercial Banks: Evidence from a Degree of Total Leverage Model, 10 J. FIN. INTERMEDIATION 54, 68-70 (2001) (finding in data for 472 U.S. commercial banks from 1988 to 1995 that diversifying from deposits and loans into non-interest revenue activities, particularly trading, strongly increases revenue volatility);
57. cf. Kevin J. Stiroh & Adrienne Rumble, The Dark Side of Diversification: The Case of U.S. Financial Holding Companies, 30 J. BANKING & FIN. 2131, 2158 (2006) (finding in data of over 1800 U.S. financial holding companies from 1997 to 2002 that any gains from diversification into non-interest revenue generation "are more than offset by" the costs of increased exposure to volatile activities).
58. Researchers affiliated with the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve have argued that bank holding companies are a source of strength for their banks because the FDIC has authority to force bank holding companies to cross-guarantee the bank's obligations. See Adam B. Ashcraft, Are Bank Holding Companies a Source of Strength to Their Banking Subsidiaries?, 40 J. MONEY, CREDIT & BANKING 273, 287-94 (2008);
59. Christine M. Bradley & Kenneth D. Jones, Loss Sharing Rules for Bank Holding Companies: An Assessment of the Federal Reserve's Source-of-Strength Policy and the FDICs Cross Guarantee Authority, 17 FIN. MARKETS, INSTITUTIONS & INSTRUMENTS 249, 269-70 (2008). This argument only operates, however, as long as the bank holding companies themselves are solvent. Our argument relates to the opposite situation, when they are not solvent and the ex ante incentives set by this possibility. The current crisis may correspond to our scenario.
60. Among other things, executives will bear costs to the extent that they have firm-specific human capital and that their professional standing would be adversely affected by such failure. In addition, banks may have deferred compensation programs and supplemental retirement accounts for their executives, and executives' rights under these programs might be adversely affected by a bank failure. For evidence on the extensive use of such programs and accounts, see, for example, Lucian A. Bebchuk & Robert J. Jackson, Jr., Executive Pensions, 30 J. CORP. L. 823 (2005);
61. Rangarajan K. Sundaram & David L. Yermack, Pay Me Later: Inside Debt and Its Role in Managerial Compensation, 62 J. FIN. 1551 (2007). As Bebchuk & Jackson explain, however, arrangements and practices indicate that executives' benefits under these arrangements may not suffer even in the event of a bank failure. Bebchuk & Jackson, supra, at 831.
62. See Carl R. Chen et al., Does Stock Option-Based Executive Compensation Induce Risk-Taking? An Analysis of the Banking Industry, 30 J. BANKING & FIN. 915 (2006) (documenting an increase of option-based compensation in U.S. banks over the period 1992-2000 and an associated increase in risk-taking);
63. Gorton & Winton, supra note 19, at 527-29 (reviewing other studies with similar findings); Luc Laeven & Ross Levine, Bank Governance, Regulation and Risk Taking, 93 J. FIN. ECON. 259 (2009) (documenting that banks around the world take more risk when shareholders have more power over management);
64. Shams Pathan, Strong Boards, CEO Power and Bank Risk-Taking, 33 J. BANKING & FIN. 1340 (2009) (documenting in a sample of U.S. banks in the period 1997-2004 that stronger boards are associated with more risk);
65. Elijah Brewer III et al., Deregulation and the Relationship Between Bank CEO Compensation and Risk-Taking (Fed. Reserve Bank of Chi., Working Paper No. 2003-32, 2003) (documenting the increase of equity-based compensation in the U.S. banking sector after deregulation in the 1990s and an associated increase in risk-taking). For a discussion of similar empirical findings relating specifically to the financial crisis of 2008-2009, see infra section I.F.
66. For example, if the bank had one hundred shares outstanding, the strike price would be eight cents.
67. If the market anticipates that the executive will choose the risky option with certainty, the value of common stock will be 1/2 · 0 + 1/2 · ($8 + X) = $4 + X/2. If the executive unexpectedly chooses the safe option, the value of common stock will increase to $8, a certain gain of $4 - X/2. If the executive chooses the risky option, the value of the common stock will either fall to zero or, if the gamble succeeds, increase to $8 + X, a gain of $4 + X/2. Hence, the expected gain from the risky strategy is 1/2 · 0 + 1/2 · ($4 + X/2) = $2 + X/4. This is greater than the certain gain from the safe strategy, as long as X is greater than $(8/3). Consequently, for X greater than $2.67, the executive can be expected to choose the risky option, and the market's expectation will be borne out. We have already discussed in the main text that the executive's incentive to gamble is even higher if the market does not anticipate it. So, we conclude that for X greater man $2.67, the only equilibrium is for the executive to always gamble and the market to fully anticipate this. For values of X below $2.67, the manager will sometimes choose the safe strategy and other times the risky strategy. Because the executive will always gamble if the market does not anticipate gambling, it cannot be an equilibrium for the executive not to gamble if X is less man $2.67. By contrast, if the market anticipated that the executive will gamble for sure, the share price would be sufficiently depressed to make it profitable for the executive to raise the share price by following the safe strategy rather than gambling - in other words, the expectation of the market would not be borne out in equilibrium. It follows that for values of X between $0 and $2.67, the only equilibrium is a mixed one in which the manager gambles with some probability, which the market anticipates.
68. The analysis of stocks as options (or the other way around) using arbitrage arguments is due to Fischer Black & Myron Scholes, The Pricing of Options and Corporate Liabilities, 81 J. POL. ECON 637 (1973).
69. The legal minimum ratio is 3%, provided the bank holding company also meets other risk-based capital measures. See 12 C.F.R. pt. 225 app. D.II.a (2009).
70. See BANK OF AM. CORP., supra note 23, at 93; CITIGROUP INC., supra note 23, at 86; JPMORGAN CHASE & Co., supra note 23, at 130.
71. See supra note 40; cf. 12 C.F.R. § 225.2(r)(1) (2009) (defining "well-capitalized").
72. See CITIGROUP INC., 2007 PROXY STATEMENT 16, 51 (2007) (reporting stock ownership as of February 28, 2007 and reporting outstanding options and their exercise prices).
73. See Citigroup Inc., Historical Price Lookup, http://phx.corporate- ir.net/phoenix.zhtml?c=97076&p=irol-historicalpricelookup&t= HistQuote&searcn.x=35&search.y=10 (last visited Aug. 17, 2009).
74. See BANK OF AM. CORP., 2007 PROXY STATEMENT 17-18, 35 (2007) (reporting stock ownership, including one million shares corresponding to possible option exercises, and outstanding options).
75. See Bank of America Corp., Historical Price Lookup, http://phx.corporate-ir.net/phoenix.zhtml?c=71595&p=irol-stocklookup (last visited Aug. 18, 2009).
76. We remain in the framework of our one-period model so that a drop in equity value is final. In a more fully specified model, stock prices might recover, and hence options would retain some positive value, if their exercise price is above uie current stock price. One can think of the one-period model as a simple way to describe the stock price development until the expiration date of the options.
77. On the consolidation of the banking industry through the 1990s, see GARY A. DYMSKI, THE BANK MERGER WAVE: THE ECONOMIC CAUSES AND SOCIAL CONSEQUENCES OF FINANCIAL C ONSOLIDATION 34-49 (1999).
78. On the reinforcement of the "too big to fail" moral hazard by this development, see GARY H. STERN & RON J. FELDMAN, TOO BIG TO FAIL: THE HAZARD OF BANK BAILOUTS 60-66 (2004).
79. See generally DEP'T OF THE TREASURY, ROAD TO STABILITY: CAPITAL PURCHASE PROGRAM (2009), http://www.financialstability.gov/roadtostability/ capitalpurchaseprogram.html;
80. DEP'T OF THE TREASURY, ROAD TO STABILITY: PUBLIC-PRIVATE INVESTMENT PROGRAM (2009), http://www.financialstability.gov/roadtostability/ publicprivatefund.html;
81. Press Release, Office of Public Affairs, U.S. Treasury Dep't, Treasury Secretary Tim Geithner, Written Testimony: Congressional Oversight Panel (Apr. 21, 2009), available at http://www.financialstability.gov/latest/tg89. html.
82. See STERN & FELDMAN, supra note 47, at 9-85 (discussing the theory and empirical evidence of moral hazard engendered by "too big to fail"); Gorton & Winton, supra note 19, at 487, 524 (discussing uie empirical evidence on the risk-taking incentives engendered by "too big to fail");
83. David G. Mayes, An Overview of the Issues, in WHO PAYS FOR BANK INSOLVENCY? 27, 29 (David G. Mayes & Aarno Liuksila eds., 2004).
84. Rüdiger Fahlenbrach & René M. Stulz, Bank CEO Incentives and the Credit Crisis 18 (Charles A. Dice Ctr. for Research in Fin. Econ., Working Paper No. 2009-13, 2009), available at http://ssrn.com/abstract=1439859.
85. Id.; see also Floyd Norris, It May Be Outrageous, but Wall Street Pay Didn't Cause This Crisis, N.Y. TIMES, July 31, 2009, at B1;
86. Andrea Beltratti & René M. Stulz, Why Did Some Banks Perform Better During the Credit Crisis? A Cross-Country Study of the Impact of Governance and Regulation (Nat'l Bureau of Econ. Research, Working Paper No. 15180, 2009), available at http://www.nber.org/papers/w15180 (empirically arguing that banks with more shareholder-friendly boards performed worse during the financial crisis of 2008-2009).
87. In fact, on a standard roulette wheel, the odds are always slightly less than fair. For example, a bet on red pays twice if successful, but the chance of winning is only 18/37, slightly less than one-half.
88. Fahlenbrach & Stulz, supra note 50.
89. See supra section I.A-I.C.
90. See Fahlenbrach & Stultz, supra note 51, at 18 (arguing that "[a] possible explanation for our results is that CEOs with better incentives to maximize shareholder wealth took risks that other CEOs did not. Ex ante, these risks looked profitable for shareholders. Ex post these risks had unexpected poor outcomes."). The finding of Beltratti & Stulz, supra note 51, at 21-22, also supports this argument.
91. The closing share price of Citigroup on March 20 was $50.64 in 2007, $22.50 in 2008, and $2.62 in 2009. See Citigroup Inc., supra note 43.
92. The closing share price of Bank of America on March 20 was $50.76 in 2007, $41.86 in 2008, and $6.19 in 2009. See Bank of America Corp., supra note 45.
93. For example, on March 26, 2009, Citigroup was able to sell $1 billion worth of ten-year bonds by promising only 3% above the UK government bond interest rate. See Shelley Smith, Citigroup Sells 500 Million Pounds of Bonds at Higher Interest, BLOOMBERG, Mar. 26, 2009, http://www.bloomberg.com/apps/news?pid=20601087&sid=azBrpNW0alig&refer= home.
94. See BD. OF GOVERNORS OF THE FED. RESERVE SYS., THE SUPERVISORY CAPITAL ASSESSMENT PROGRAM: OVERVIEW OF RESULTS (2009), available at http://www.federalreserve.gov/ newsevents/bcreg2009507a1.pdf. It should be noted, however, that some observers questioned whether the criteria applied by regulators to examine the adequacy of banks' capitalization were sufficiently comprehensive and rigorous.
95. See CONG. OVERSIGHT PANEL, JUNE OVERSIGHT REPORT: STRESS TESTING AND SHORING UP BANK CAPITAL 4, 33-35 (2009), available at http://www.cop.senate.gov/documents/cop-060909- report.pdf.;
96. Lucian A. Bebchuk, Toxic Tests, PROJECT SYNDICATE, June 2009, http://www.project-syndicate.org/commentary/ bebchuk2.
97. See Google Finance, Historical Prices for XLF (Financial Select Sector SPDR (ETF)), http://www.google.com/finance/historical?cid= 700196&startdate=Dec1%2C2006&enddate=Sep1%2C2009&start=690&num= 30 (last visited Sept. 1, 2009) (comparing the price at close of business of both days).
98. See BANK OF AM. CORP., 2009 PROXY STATEMENT 27 (2009), available at http://media.corporate-ir.net/media-files/irol/71/71595/reports/2009-Proxy.pdf (reporting exercise prices of options granted between February 2005 and February 2008).
99. See Bank of America Corp., supra note 45.
100. See Stewart C. Myers, Determinants of Corporate Borrowing, 5 J. FIN. ECON. 147 (1977).
101. See JPMorgan and 9 Other Banks Repay TARP Money, http://dealbook.blogs.nytimes.com/2009/06/17/jpmorgan-repays-treasury-as-tarp- exits-continue/ (June 17, 2009, 16:17).
102. See supra notes 4-6.
103. See generally BEBCHUK & FRIED, supra note 2 (discussing why governance reforms are the best way for dealing with executive compensation flaws in general).
104. See 12 U.S.C. § 5221(b)(3)(D)(i) (2009) (codifying the EESA and incorporating amendments pursuant to the American Recovery and Reinvestment Act of 2009). Treasury guidelines issued under the original EESA in February 2009 had imposed slightly less stringent rules; in particular, they allowed most TARP recipients to opt out of this requirement. See Press Release, supra note 6.
105. The statute requires that the long-term restricted stock not fully vest during the time that the company owes TARP money to the government. See 12 U.S.C. § 5221(b)(3)(D)(i)(I). Similarly, the Treasury guidelines require that restricted stock awards to senior executives of companies receiving "exceptional assistance" vest only after the government has been paid back in full with interest. See Press Release, supra note 6.
106. See supra notes 2-3 and accompanying text.
107. See 12 U.S.C. § 5221(e) (codifying the EESA and incorporating amendments pursuant to the American Recovery and Reinvestment Act of 2009). The Treasury guidelines already contained a similar requirement for recipients of exceptional TARP assistance. See Press Release, supra note 6.
108. See Corporate and Financial Institution Compensation Fairness Act of 2009, H.R. 3269, 111th Cong. § 2 (as passed by House, July 31, 2009).
109. See Empowering Shareholders on Executive Compensation: Hearing Before the H. Comm. on Fin. Servs., 110th Cong. (2007) (written statement of Lucian A. Bebchuk et al., Professor, Harvard Law School), available at http://www.law.harvard.edu/faculty/bebchuk/pdfs/2007-HFSC.pdf.
110. Cf. Jeffrey N. Gordon, "Say on Pay": Cautionary Notes on the U.K. Experience and the Case for Shareholder Opt-In, 46 HARV. J. ON LEGIS. 323, 365 (2009) (arguing that shareholders will not take into account, and hence will not eliminate, the systemic risk resulting from their compensation decisions).
111. See supra note 35.
112. See BASEL COMM. ON BANKING SUPERVISION, supra note 7, at 26. Nonbinding recommendations to this effect were already contained in BASEL COMM. ON BANKING SUPERVISION, ENHANCING CORPORATE GOVERNANCE FOR BANKING ORGANISATIONS 14-15 (2006).
113. See Press Release, supra note 1.
114. See Corporate and Financial Institution Compensation Fairness Act of 2009, H.R. 3269, 111th Cong. § 3 (as passed by House, July 31, 2009).
115. See Press Release, U.S. Dep't of Treasury, Fact Sheet: Administration's Regulatory Reform Agenda Moves Forward: New Independence for Compensation Committees (July 16, 2009), available at http://www.treas.gov/press/releases/tg218.htm
116. (citing Lucian Bebchuk et al., Lucky CEOs and Lucky Directors, J. FIN. (forthcoming);
117. April Klein, Audit Committees, Board of Director Characteristics, and Earnings Management (N.Y. Univ., Law & Econ. Research Paper, Paper No. 06-42, 2006)).
118. For a detailed argument along these lines, see BEBCHUK & FRIED, supra note 2, at ch. 16.
119. Some believe that as long as shareholder influence is not excessive, boards will and should pursue the interests of stakeholders as a whole, rather than just shareholders. See, e.g., Margaret M. Blair & Lynn A. Stout, A Team Production Theory of Corporate Law, 85 VA. L. REV. 247, 320-23 (1999). It is not at all clear, however, why boards would have an incentive to do so.
120. See, e.g., Lucian A. Bebchuk, The Case for Increasing Shareholder Power, 118 HARV. L. REV. 833, 909-12 (2005).
121. Prior proposals to include executive compensation within the ambit of banking regulation include Kose John et al., A Theory of Bank Regulation and Management Compensation, 13 REV. FIN. STUD. 95, 96 (2000).
122. See supra notes 7, 10 and accompanying text.
123. See BD. OF GOVERNORS OF THE FED. RESERVE SYS., supra note 12; BD. OF GOVERNORS OF THE FED. RESERVE SYS., supra note 14.
124. See Corporate and Financial Institution Compensation Fairness Act of 2009, H.R. 3269, 111th Cong. §§ 2-3 (as passed by House, July 31, 2009).
125. See BASEL COMM. ON BANKING SUPERVISION, supra note 7, at 26-27. The last principle requires banks to provide "comprehensive and timely information about their compensation practices to facilitate constructive engagement by all stakeholders" but adds that this "includ[es] in particular shareholders." Id. at 27 (emphasis added); see also FIN. STABILITY FORUM, FSF PRINCIPLES FOR SOUND COMPENSATION PRACTICES (2009), available at http://www.financialstabilityboard.org/publications/r-0904b.pdf (expanding on these principles and relied upon by the Basel Committee in proposing its enhancements).
126. FIN. SERVS. AUTH., supra note 10, ¶ 1.24.
127. Among the documents recently issued by regulators, the proposed guidance published by the Federal Reserve Board - with whose staff we had the opportunity to discuss our work - came closest to recognizing fully that even well-governed companies cannot be relied on to avoid risk-taking incentives that are excessive from a social perspective. See BD. OF GOVERNORS OF THE FED. RESERVE SYS., supra note 14, at 2.
128. On the international level, the current relevant regulation is contained in the revised Basel accord (Basel II). See BASEL COMM. ON BANKING SUPERVISION, supra note 22; see generally LAURENT BALTHAZAR, FROM BASEL 1 TO BASEL 3: THE INTEGRATION OF STATE-OF-THE-ART RISK MODELING IN BANKING REGULATION (2006) (providing an historical overview, explanations of the main features, and possible extensions of the Basel accord); MALLOY, supra note 22 (same).
129. For the United States regulation on bank holding companies, see Bank Holding Companies and Change in Bank Control (Regulation Y), 12 C.F.R. § 225 (2009).
130. See, e.g., PADOA-SCHIOPPA, supra note 21, at 2-3.
131. See, e.g., Charles W. Calomiris, Financial Innovation, Regulation, and Reform, 29 CATO J. 65, 65-66, 71-72 (2009) (describing the bank practice of keeping risks off balance sheets and gaming risk regulation by encouraging inflated debt ratings by credit rating agencies);
132. Henry T.C. Hu, Misunderstood Derivatives: The Causes of Informational Failure and the Promise of Regulatory Incrementalism, 102 YALE L.J. 1457, 1463 (1993) ("Observers agree that regulators know less than the bankers, and that they know too little.");
133. Henry T.C. Hu, Swaps, the Modern Process of Financial Innovation and the Vulnerability of a Regulatory Paradigm, 138 U. PA. L. REV. 333, 392-412 (1989) [hereinafter Hu, Swaps] (noting that financial innovations often cross existing regulatory classifications, and that
134. See, e.g., James R. Barth et al., Reassessing the Rationale and Practice of Bank Regulation and Supervision after Basel II, in 5 CURRENT DEVELOPMENTS IN MONETARY AND FINANCIAL LAW 225, 227 (2008) (noting that "[m]ost supervisory agencies will never have sufficient human capital or budgets to implement Basel II successfully");
135. Hu, Swaps, supra note 90, at 395-96.
136. See, e.g., BD. OF GOVERNORS OF THE FED. RESERVE SYS., STAFF STUDY 172 - USING SUBORDINATED DEBT AS AN INSTRUMENT OF MARKET DISCIPLINE 1 (1999);
137. see also Philip A. Wellons, Enforcement of Risk-Based Capital Rules, in CAPITAL ADEQUACY BEYOND BASEL, supra note 25, at 284 (reporting "very low levels of enforcement of capital requirements in the United States between 1993 and 2001, particularly for larger firms," but noting that "this may result from the fact that such firms are adequately capitalized").
138. See generally Calomiris, supra note 90.
139. See supra note 35. More generally, much of corporate governance research is concerned with the problem that managers will not implement shareholders' wishes, a problem first clearly articulated in Jensen & Meckling, supra note 19, at 312-30 (calling this the "agency cost of outside equity").
140. See BD. OF GOVERNORS OF THE FED. RESERVE SYS., supra note 14, at 2.
141. Some commentators have proposed adjusting FDIC premia in relation to the bank's executive compensation formula and argue that this approach can achieve the socially optimal level of risk-taking. See John et al., supra note 81, at 98. The commentators emphasize mat their proposal would require "no direct or mandatory regulation of management compensation." Id. at 122. To implement titis approach, however, the FDIC would have to have knowledge of the distribution of possible returns for possible loans of the bank (in other words, repayment rates), id. at 113, which the FDIC is unlikely to be able to acquire.
142. One of us has written extensively on how executive compensation should be best designed to align executives' and shareholders' interests. See supra notes 2-3, 34.
143. While shareholders of firms outside the banking sector (or directors elected by such shareholders) should not be constrained by regulators in setting the structure of executive pay arrangements, firms seeking to reduce their borrowing costs should be free, of course, to agree to covenants that require them to tie executive pay to the value of the firm's debt securities. For theoretical analyses of whether and when such covenants could be efficient, see David Hirshleifer & Anjan Thakor, Managerial Conservatism, Project Choice, and Debt, 5 REV. FIN. STUD. 437 (1992);
144. Teresa John & Kose John, Top-Management Compensation and Capital Structure, 48 J. FIN. 949 (1993);
145. Alex Edmans, Inside Debt (EFA 2007 Ljubljana Meetings Paper, 2008), available at http://ssrn.com/abstract=758508.
146. See BD. OF GOVERNORS OF THE FED. RESERVE SYS., supra note 14, at 2.