Financial Institution Executive Compensation: The Problem of Financially Motivated Risk-Taking, the Regulatory Response, and Common Sense Solutions
Jesse D. Gossett
Posted Friday, May 16, 2014

The year 2008 witnessed the greatest economic downturn in over seventy years. Excessive compensation was often cited as a major contributor to the Great Recession. In response, Congress enacted Dodd-Frank, which contains a handful of compensation-related reforms including a clawback for erroneously paid bonuses. However, none of these reforms does anything to address the true link between executive compensation and the Great Recession: compensation plans that encourage excessive risk taking. Under the current state of the law, Dodd-Frank does nothing to stave off a repeat of that disaster. Fortunately, one aspect of Dodd-Frank, Section 956, offers a glimmer of hope. It requires regulators to create rules that prohibit compensation plans at financial institutions that encourage excessive risk taking. Unfortunately, to date, no such rules have been enacted.

This Article supplies what Section 956 is currently missing. Because all bonuses are ultimately the result of risk-taking decisions, this Article suggests that all financial institution executive compensation plans must contain an ex ante risk assessment that may defer receipt of the bonus. This delay acts as risk to the executive that he or she may never actually receive the bonus and this risk is proportional to the risk taken by the firm to calculate the bonus in the first place. This Article further suggests an ex ante risk assessment to develop a sliding scale between how much of the bonus must be in cash and how much in equity.

If these suggested reforms are implemented financial institution executives would now consider how the risks they take with their firm’s assets directly impact the risks to their own bonuses. The end result would be a reduction in risk at financial institutions and a reduction in the likelihood or severity of the next financial-institution-created economic downturn.