Everyone has a theory about what caused the 2008 financial crisis. One idea that’s made the rounds is that the money flashed at bank executives in the form of salaries and bonuses encouraged them to take big risks that maximized short-term profits at the expense of long-term viability. The U.S. Financial Crisis Inquiry Commission asserted as much when it connected the crucial 2008 failure of the investment bank Lehman Brothers in part to an executive compensation scheme “that was based predominantly on short-term profits.” In the United Kingdom, the chairman of the Financial Services Authority linked “inappropriate incentive structures” with risk-taking and the financial turmoil of 2007–09.
The finger-pointing may be unwarranted, says University of Bath finance professor Ian Tonks. The financial sector differs from other corporate sectors “not so much in its reward for taking risks, but in its reward for expansion,” he writes, summarizing research he did with several colleagues.
The group compared the salaries and bonuses of executives across all British industries from 1994 to 2006, just before the financial crisis hit. Not surprisingly, the financial sector boasted some of the highest pay rates for executives and board members. Yet the relationship between firms’ performance and executive pay was not much different from that in other industries. A 10 percent increase in company stock price was associated with a measly 0.68 percent increase in executive compensation. “In other words, executives were paid irrespective of performance,” Tonks writes.
The researchers found a stronger correlation between executive pay and firm size in the financial sector: When a firm’s assets increased by 10 percent, executive pay rose by two percent. If regulators want to protect against another financial crisis, it seems they’d be better off trying to decouple executive pay from the expansion of financial empires.
THE SOURCE: “Bankers’ Bonuses and the Financial Crisis” by Ian Tonks, Vox EU, Jan. 8, 2012.