Help Prevent a Sequel. Delay Some Pay. - Commentary by Robert J. Shiller
"Help Prevent a Sequel. Delay Some Pay."
By Robert J. Shiller
Published June 18, 2010 in the New York Times.
Read the article in its original context on the New York Times website.
Congress’s approach to financial reform has been a bit like my own household’s response to a moth infestation in our kitchen a couple of years ago. After we got over the initial shock, my wife and I responded rapidly, disposing of food in which moths were breeding. Then we broadened our focus, throwing away items that had passed their expiration date or were no longer needed. Then we made a list of things to buy and went shopping.
But, in retrospect, we neglected something important. We didn’t take control of the crisis by finding where the moths came from, or figuring out how to prevent their return. (Just two weeks ago, we found another infestation.)
How does that compare to the federal response to the financial crisis?
Well, now that we’re past the initial phases of crisis management, Congress has a chance to address the underlying issues in a fundamental way. Unfortunately, though, the reform bills approved separately by the House and the Senate — and now in conference committee — deal with the crisis by offering a host of little cleanups and shopping lists. The cumulative effect would certainly be positive, but the current versions wouldn’t really prevent a repeat of the mess.
There may be a better way. I have been working as part of a nationwide group of 15 professors of financial economics on recommendations to improve our chances. Organized by Kenneth French of Dartmouth, we call ourselves the Squam Lake Group, after the New Hampshire lake where we began in 2008 to think together and pool our expertise.
We made extensive use of an important tenet of economic theory: People respond to incentives, but the incentives embedded in government regulations often don’t have their desired effects. Beginning economics students have been known to have epiphanies about the surprising outcomes of many such incentives.
Last Wednesday, we presented our findings, “The Squam Lake Report: Fixing the Financial System” (Princeton University Press). Ben S. Bernanke, the chairman of the Federal Reserve, helped introduce the book at a conference at Columbia University. He said he agreed with the principle that “the stakeholders in financial firms — including shareholders, managers, creditors, and counterparties — must bear the costs of excessive risk-taking or poor business decisions, not the public.”
But the current legislation does not yet fully satisfy our criteria.
The issues facing us are complex. Let’s look at just one of them: the provisions in the Congressional bills on executive compensation.
Certainly, executive pay has grown enormously in recent decades, and there has been much suspicion that it contributed to the crisis. But it’s not the high level of executive salaries that helped cause the financial collapse. Efforts to reduce executive salaries have perversely created the wrong incentives. A 1993 law discouraging companies from paying their chief executives more than $1 million a year appears to have led to a de-emphasis of salaries and an increase in stock options.
So here is one of those epiphanies: Those stock options didn’t lower total compensation. And they probably encouraged C.E.O.’s to expose their companies to more risk, because options’ value grows as risk does. In fact, legislators’ misunderstanding of the law’s true incentives may have contributed to the severity of the crisis.
The Senate bill contains requirements about compensation committees, the disclosure of pay structure, and provisions that give shareholders an opportunity to express opinions on executive salaries — a “say on pay.” These provisions may help discourage crony boards from overpaying C.E.O.’s, but won’t do much to stabilize the system.
In contrast, the Squam Lake group recommends that companies be encouraged to withhold a good part of the compensation of their top executives for a number of years, and that it should not take the form of stock options. That would give them incentives to consider some of the long-term consequences, and intrinsic value, of their decisions.
The holdback should be for a pre-announced dollar amount, and the contract should specify that it will be lost if the company goes bankrupt or gets a government bailout. That way, the economic cost of a bankruptcy or bailout is placed partly on the executives who make decisions. The riskiness of the company’s activities becomes the executives’ personal problem, not just the taxpayers’. That should transform executives’ thinking about risks — and may help prevent another disaster.
The Senate bill does have clawback provisions that might take back an executive’s compensation at a later date, under special circumstances. But these provisions wouldn’t likely have the transforming effect of a holdback.
IF our holdback measure had been in place before the last crisis, executives might have had serious second thoughts about giving a green light to mortgage-backed securities that would later go bust.
Both the House and Senate bills contain a requirement that mortgage securitizers share in the risk — by retaining an interest in any mortgage-backed securities they create, and not selling them all off to investors. That improves incentives, which is a good idea, but it has a narrow application.
The next crisis will take an unexpected form. Crises generally do. We need regulations that are based squarely on economic theory — sturdy incentives that really accomplish their broad mission.
Robert J. Shiller is professor of economics and finance at Yale and co-founder and chief economist of MacroMarkets LLC.