Macroprudential Policy and Monetary Policy

Jared Bernstein sends us to Stanley Fischer's speech about financial regulation. Unsurprisingly, I agree with Jared's ideas about human behavior in finance.  As Robert Shiller and others have long argued, humans behave weirdly sometimes - falling into traps of euphoria and panic.  A little more broadly, even Keynes noted that some things are just fundamentally uncertain and thus "animal spirits" guide many actions in the economy.

What I am struggling with now is not human behavior in finance but the contradiction between expansive monetary policy and prudential macro policy. Recent expansionary monetary policy leading up to the housing bubble demonstrates how pumping money into the economy can not only cause misallocation of funds, but also increase the fragility of the overall system.

Macroprudential policy could improve the strength of the financial system and help allocate funds to non-bubbles, however when you try to guide a river into specific channels, it might lose some oomph. Likewise, monetary policy will be less stimulative due to restraints such as capital and liquidity requirements.

To me, fiscal stimulus is an obvious answer but in the present political arena, I'm not sure we can count on it. Therefore, we need to think of how monetary policy interacts with prudential regulation.

Pay without Performance: Long, Long Summary

At the heart of the corporate governance structure lies an agency problem.  Shareholders (owners) cannot constantly supervise the managers  (controllers).  Some mechanism to force managers to keep shareholder interests in mind has to be in place, otherwise executives would always act in their own best interest.  Enter the board of directors.  The board of directors was created to champion shareholder interests and vested with the power to run the company.  This trifecta of managers, directors, and shareholders allegedly operates under the arm’s length bargaining model which states the executive “comes seeking the best possible deal for themselves  and board comes seeking the best possible deal for the shareholders” (2).  

However the authors argue arm’s length bargaining has hardly been the case. After thoroughly inspecting executive compensation Bebchuk and Fried find that directors stand to gain much by supporting executives and suffer little cost of neglecting shareholders. Furthermore, the “checks” of shareholder action and the market do not provide the constraints financial economists believe.

It is assumed directors have shareholders interests in mind because they are mandated to do so, but upon further examination the authors find strong incentives for directors to please executives and weak incentives to look out for shareholders. 

Incentives to favor executives, small costs to ignoring shareholders, lack of market or shareholder limitations

Being a director comes with good pay, perks from the company, networking, low workloads, and extra business.  A seat on a company board is no doubt desirable.  Keeping the board seat is also attractive. A director obtains a seat by first being nominated by the current board’s nominating committee.  Nominating committees historically have not been independent .  In the past, having CEOs on nominating committees was not uncommon.  Recently, under new requirements, nominating committees have had to include more independent directors.  However, CEOs still maintain influence over nominations through independent directors desire to maintain good terms with the CEO. The work to get on good terms with the CEO and thus the slate for nomination is validated because once on the slate, being reelected to the board is almost a given.  For example a study looking at the years 1996-2002 found that “electoral challenges to board’s slate was practically nonexistent” (25). 

Once on the board, the financial and nonfinancial incentives to remain in good standing with the executive strengthen.  Financially, high CEO pay has been linked to higher board pay (30).  CEOs have power to give directors business, engage in pet projects, or contribute to director-favored charities (28).  This type of “back scratching” is inherent throughout board-executive relations and is exemplified by “interlocking” in which one executive sits on a director’s board and vice versa.  Non-financially, social and psychological factors also influence directors to favor executives over shareholders.  Besides becoming friends with executives and the desire to avoid conflict, some directors may experience cognitive dissonance where directors were previously or are currently executives and thus a lot higher CEO pay.  The magnitude of cognitive dissonance is by no means a small percentage. For example, in 2002, “41% of the directors on compensation committee were active executives” (33).  

Directors hold infinitesimal amounts of shares (34), allowing them to make choices that could decrease shareholder value yet benefit an executive. 

Assuming directors do have shareholder interests in mind, they are still constrained by time and lack of information, a study completed in 2001 finds that directors only worked about 100 hours a year (37). Thus the widespread use of compensation consultants should come to no surprise.  Compensation consultants are justified as impartial, a resource with an objective perspective that has access to other private company information, which many courts defer to in litigation.  However, compensation consultants also have strong incentives to please managers and no incentives for shareholder loyalty. Consultants seek future business and give the executive the news they want to hear.  Compensation consultants can boost CEO pay regardless of performance, “when a firm did well, consultants pushed for high compensation…when a firm did poorly, the consultant looked not to performance but rather to peer group pay norms” (39). 

Proponents of arm’s length bargaining claim shareholder action and market constraints will limit any deviations from the arm’s length model.  Bebchuk and Fried demonstrate the multiple barriers shareholders face in challenging the board.  A major obstacle facing shareholders that wish to challenge the board via litigation is the history of court action; courts don’t have the competency to judge compensation packages and thus have almost never overturned board decisions (46).  Courts defer to board decisions if minimum requirements are met (independence of comp committee), throw out cases due to formalities like the demand requirement (bringing a demand to the board before entering any legal cases), and the last route options like “waste” have been described as rare as the Lock Ness monster (46). In other words, the “check” of shareholder action on executive compensation has no teeth.

Because CEOs and other executives are at the top of the corporate latter, normal market forces don’t constrain their compensation.  They can’t move up, are unlikely to be picked up by different firm, and rare cases of dismissal is most certainly not due to compensation requests.  

Directors recognize pleasing executives can yield substantial benefits and the cost directors incur for neglecting shareholders is negligible.  Furthermore, constraints provided via shareholder action and the market are ineffectual.  

Managerial power existence and how it is used to extract rents and decouple pay from performance

It is clear the arm’s length bargaining model is not equipped to explain current executive compensation agreements; incentives influence the board to favor executives and not shareholders while there are no effective constraints to combat this effect. The authors develop and offer a managerial power approach that better explains executive compensation and the relationships between the board, managers, and shareholders. 

Under this approach, managers can extract rents  by camouflaging compensation under the outrage constraint.  The outrage constraint reflects the fact executives cannot receive infinite amounts of compensation without protest by shareholders and other community members. An example of the outrage constraint is CalPERS strategy of publicly shaming companies/CEOs that were performing poorly which lead to increased CEO turnover (69).  Managers also use their power to decouple their pay from their performance.  Executives are compensated for activities that do not reflect increased shareholder value. By camouflaging their pay, managers can extract rent, receive pay not related to their performance, and provoke little outrage. For example, compensation consultants can assist in camouflage by expanding and/or changing definitions to boost CEO pay (71).

The ratcheting effect of managers all wanting to be above average – leading to higher and higher pay reflects managerial power. For instance, instead of having to substitute cash compensation for equity based pay, executives received equity payments on top of already existing cash components. As seen later, the shift to equity payments could have been performance based but managers choose to pursue and maintain equity arrangements that were not strongly linked to performance.  

Certain environments can confer more power onto managers: larger boards, no large outside shareholders, no institutional shareholders, and protection from takeovers. Executives can utilize this power to garner not only more pay but pay that is less predicated on performance. 

CEO pay tends to be higher and less performance sensitive when the board is larger, directors serve on more than one board, and when directors are “attached” to CEOs either through interlocking or being appointed by CEO.  Psychological factors allow directors to be more generous when they can’t be the only one blamed or when they know the executive personally.

Both large outside shareholders and the presence of institutional investors place downward pressure on executive pay. A 2002 study found “a shareholder with a stake larger than the CEO’s ownership interest reduces CEO compensation by 5%” (82). Furthermore, studies show CEOs of companies with large external shareholders  are less likely to be rewarded for luck (83).

Under the arm’s length approach, shareholders should not have any obligations to outgoing executives, so it is puzzling why they receive so much compensation.  Using a managerial power lens, it is clear executives leverage their power to secure excess compensation on the way out.  Gratuitous payments are payments not stipulated in the CEOs contract.  CEOs that warrant firing should not receive compensation upon leaving, however Bebchuk and Fried describe several examples of fired executives receiving millions of dollars of gratuitous compensation (88).  An explanation for the excess payments to CEOs points to repaying old favors than with performance (93). 

Acquired companies executives also receive bonus payments from their boards. Since acquired companies usually benefit in some way, this bonus might not reflect managerial manipulation.  On the other hand, executives also get bonuses from the acquiring firm board, which can lead to lower acquisition premiums for shareholders (92). In this case, CEOs benefit at the expense of shareholders.

Gratuitous payments and bonuses from acquiring firms have little to nothing to do with performance and exemplify extracting rent. Retirement benefits demonstrate how managerial power influences firms to camouflage executive pay to lower outrage costs and how these benefits do not increase shareholder value. 

The then recent corporate scandals such as Enron prompted legislation such as the Sarbanes-Oxley act and tighter disclosure requirements.  Retirement benefits offer various ways to circumvent disclosure requirements and again separate compensation from performance.  Additionally, retirement benefits extended to executives do not contain favorable tax treatments for the firm and thus can only be the result of managerial power.

Regular or “qualified” pensions are considered efficient because they offer tax subsidies to the firm. Because these qualified plans can only pay out $100,000 annually (97), CEOs usually are covered by supplemental executive retirement plans or SERPs. SERPs, unlike regular pensions, “shift some of the executive’s tax burden to the firm” (97). SERPs also shift the risk of bad investment yields to the firm from the manager.  Since regular pensions are defined contribution, firms put in a defined amount but the benefit amount depends on investment yields.  SERPs alternatively are defined benefit meaning even if the investments have poor yields, the firm has to make up the difference.  Furthermore, SERP payments “are usually based on years of service and preretirement cash” (99) meaning performance is not linked to pay. It allows firms to hide build up of executive payments and past executive payouts. Why are executives different then regular employees?  The authors point out that executives more than regular employees would be better equipped to handle the risk of bad investment yields. The fact that in 2002 70% of firms supplied SERPs to their executives (98) may be an effect of managerial power.

Like qualified pensions, regular employees have 401(k)s but executives are allowed to defer compensation. And like SERPs, under deferred compensation managers receive substantial gains at the expense of the firm and shareholders.  The deferred compensation “builds according to a formula devised by the firm” (102).  Interestingly enough, usually the yield from this formula is above market returns.  If executives invested money themselves they would be subject to a 15% capital gains tax. Deferred compensation is subject to 35 percent corporate tax, thus it is again puzzling that “over 90 percent of firms offer deferred compensation” (105).

Retirement perks including “access to apartments, planes, cars, home-security devices, and financial planning” (107) highlight the desire to hide compensation. It would yield more utility if the executives received cash equivalent compensation and could decide for themselves what they’d like to do with the money.  However, perks camouflage the true value of extra compensation given to managers. Consulting contracts further exemplify camouflage and the decoupling of pay from performance. For example one executive received 1 million dollars for being available 5 days a month for one year (109).

Golden goodbyes and retirement perks do not make sense under an arm’s length bargaining model but can be understood via the  managerial power approach.  Executives utilize their power to not only extract excess compensation but to decouple their pay from their performance.  The next section examines CEO compensation and continues to document examples of this process.

Historically non-equity pay has not been correlated with performance and thus regulators instituted a rule that says firms cannot deduct more than 1 million dollars of CEO compensation unless that compensation is performance based.  However, CEOs have received salary and bonus beyond 1 million (122). In other words executives receive cash compensation at a disadvantage to firms and shareholders. Even further, CEO cash compensation is highly correlated to events not necessarily related to executive decisions like market-wide or sector-wide stock price increases. Allowing CEOs to reap benefits of results they did not help produce.

Unlike salary, bonuses have to meet objective and subjective criteria to be awarded. Objective criteria appear impartial and perhaps reasonable guidelines to allocate bonuses.  Upon closer inspection, it seems most objective requirements have little or nothing to do with increasing shareholder value.  Examples of such objectives include meeting a budget or having current profits exceed the previous year. Meeting a budget does not display any improvement to shareholder value while aiming at higher profits than the previous year can distort incentives for long-term success. A company could rank at the bottom of peer firms yet have higher numbers than last year. Moreover, the objective creates an incentive to make earnings look higher than they really are, “For example, companies have based bonuses on accounting earnings that include the appreciation of pension fund investments, which generally depend on stock market performance and not on the efforts of the companies’ executives” (125).  According to the authors, in 2001 Verizon awarded bonuses based on the net income for the year, which included about 2 billion dollars of pension appreciation income from investments (125). If the company did not include the appreciation, net income would have been negative. 

Executives also receive bonuses for making acquisitions that do not necessarily increase shareholder value, “A 2002 BusinessWeek study examining large acquisitions made in the spring of 1998 concluded that 61% of the buyers ‘destroyed their own shareholders’ wealth’ in the process by overpaying for their targets” (128).  Executives have monetary and non-monetary incentives to acquire firms, via bonuses or empire building respectively. Yet, there are no incentives to downsize.  Acquisitions therefore appear to be just another reason to hand out cash to CEOs.

Golden hellos such as signing bonuses represent pay that relates in no way to performance. Golden goodbyes even in the face of terrible tenure represent pay decoupled from performance, “Currently, most compensation contracts ensure that executives receive generous treatment even in cases of spectacular failure” (133). For example, Jill Barad received 50 million after overseeing a two-year stock decline of 50% (134).

Again, cash compensation has been historically weakly correlated with performance.  As fact became more apparent to shareholders they began to demand some type of performance-based pay.  Reflecting common feelings, the federal tax code in 1994 stipulated publicly traded companies cannot deduct pay in excess of 1 million annually per executive unless pay was based on performance or pay was granted via options.

  

Interestingly, the shareholder pressure led to an increase in option based plans while performance based plans were largely ignored.  Perhaps due to managerial power, when shareholders and institutional investors won their campaign for option plans, they were ADDED ON TOP of current cash compensation and not substituted out.  Inflated CEO pay produced little outrage largely because of the booming market of the 90’s.

Options (call) are promises that one can buy a company’s stock for a specific price, called the exercise or strike price.  The idea behind options based compensation packages is that the more stock an executive has, the more aligned the interests of the executive and shareholders will be.  

To test whether option plans really carried out their intended effect, shareholders use the share price to determine executive performance.  Share price seems like a good gauge of performance since increasing the share price is good for all shareholders, including the CEO, but without significant adjustments it isn’t. Many things can lift a share price without any intervention by a manager- for example,  a study found “only 30% of share price movement reflects corporate performance, the remaining 70% is driven by general market conditions” (139). Additionally, falling interest rates and the general upward trend of the stock market can produce windfalls for executives.

The most popular way to reduce windfall options is to index the exercise price to market average or average of a basket of peer firms.  This way, any market or sectoral swings won’t reward the executive; only good performance would reward managers. Another way to reduce windfalls for managers is to tie vesting to performance.  In other words, CEOs could not exercise their options unless certain goals were met.  

Some defend conventional options by stating reduced windfall options would change the accounting treatment regular options can garner.  If the exercise price is fixed, the firm does not have to take a charge against earnings.  Meaning under conventional options, earnings are inflated. Higher earnings could mean higher shareholder value. (148).  Taking a charge against earnings is known as expensing and it is the main reason firms put forward for avoiding reduced windfall options. However, as the authors note, expensing all options will most likely be required after 2004 by all firms, leaving no excuse to move towards reduced windfall options. The non-existent presence of reduced windfall plans even in the face of calls from institutional investors (Institutional Shareholder Services, Council of Institutional Investors) reflect managerial power “In 2002 only 8.5 percent of large public firms issuing options to executives conditioned even a portion of the grant on performance” (143).

Three more activities represent managerial power and how it has been used to decouple pay from performance: at-the-money options, backdoor repricing, reload options.

In-the-money options are not considered performance based because they have a strike price below the current market price.  The executive could buy at a low price and sell at a high price and the difference the executive made would have nothing to do with their performance.  At-the-money options have a strike price equal to the current market price.  This seems fair.  However, recalling the market’s general trend upward, at-the-money options soon become in-the-money and again can have nothing to do with performance.  Out-of-the money options have a strike price higher than the current market price, so for options to be profitable, the share price would have to be higher than the current market price.  This option out of the three has the most incentive for executive to raise the share price, even though the share price could rise on its own.  Under the managerial power model, it is not surprising then that less than 5% of companies use out-of-the-money options (160).

In 1992 95% of options were at-the-money (160).  This represents executives maximizing their gains under the outrage constraint. Of course managers would like in-the-money options but those cause outrage because there is no shareholder benefit.  Managers strongly oppose out-of-the money so the “compromise” is at-the-money. Even then managers “camouflage in-the-money as at-the-money” (164). Siebel systems “issued 600k options at-the-money with a share price of $33. The next day the company disclosed large increase in profits, driving the stock up to $46 per share. This increased executive options by 8 million” (163) and immediately turning at-the-money options into in-the-money. If Siebel had waited to grant the options at the time of the news release, no extra value would have been conferred to the options. 

Related is an activity known as repricing or backdoor repricing. This allows the exercise price in option plans that have gone out-of-the money to be lowered, in effect rewarding the manager for a decreased share price.  Repricing exemplifies managerial power, and their objective of structurally decomposing pay and performance.

A better way to organize option plans is to allow “the strike price to increase over time at predetermined rate” (161).  Since the stock market tends to rise over time, managers couldn’t be rewarded for something they had no influence over. Conventional options reward general market increases, but when the general market happens to decrease the options are repriced. This environment produces “heads I win, tails I don’t lose” (167) odds.  

Reloads are a particular mind-boggling type of compensation considering the purpose of options based pay.  Options allow executives to become shareholders, hopefully aligning their interests.  However, once options vest, CEOs own the options and most likely can exercise them the same day.  While it is not required CEOs sell the shares, evidence shows most do, “For every 1000 new options awarded, an executive sells 684 shares of stock” (174). Reload options allow executives who have sold stock to be “reloaded” with more options in order to replace the incentive to have shareholder interests in mind. 

A type of in-the-money option although not called it by name is restricted stock.  Restricted stock has a strike price well below the grant-date price – zero.  The justification for restricted stock is that it will provide some sort of long term-value, however restricted stock appears to behave identically to conventional options.  The selling of restricted stock is even worse than conventional options; in 1997 a study found for every 1000 new restricted stock awarded, an executive sells 940 shares of stock (174).

This pattern of “unwinding” erases the incentive options create. If executives can exercise options as soon as they vest and sell them, shareholders will either have less incentive for CEO to act in their interest or the same incentive at the price of granting more options.  

Not only are there no meaningful restrictions on unwinding but also managers stand to make additional gains by timing the selling of shares (179). There are countless examples of executives selling shares before bankruptcy or share price declines (181).  One striking example documents “Qwest insiders sold 2 billion while they were overstating revenues.  Shortly after, Qwest stock feel more than 95%” (182). For this reason, it is recommended that executives disclose in advance their desire to sell shares.  

The solution of equity based compensation shareholders fought so hard for has not been effective.  Instead of aligning shareholder and executive interest as previously thought, executives have been able to use their power to extract pay that is unrelated to their performance.  Much of this pay has been obscured and camouflaged to lower outrage and secure the maximum amount of managerial compensation under those constraints.  

The solutions the authors suggest are two-fold: treating the symptoms of the underlying problem and to treat the underlying problem.  Inflated executive compensation is largely a result of corporate governance malfunction.  To improve executive compensation, firms can link pay to performance, improve transparency, and require shareholder approval.

As discussed both non-equity pay and equity compensation are weakly linked to CEO performance.  To strengthen this link, companies can embrace policies like reduced windfall options – options that do not reward general market or sector-specific rises.  Revise the ways in which managers receive bonuses by deleting discretionary criteria and rewards for acquiring other businesses.  Restrict the sale of shares and require sales to be announced in advance.  Do not reward executives for failures.  Inspect the size and scope of retirement perks.

Transparency can be improved by expensing options.  This would not only reflect more accurate earnings numbers but also remove a key barrier to utilizing reduced windfall options. Firms can reduce camouflage by providing accurate monetary values on all forms of CEO compensation. 

Requiring shareholder approval could give teeth to intervention opportunities shareholders already have.  Voting on specific compensation components could give shareholders the chance to reject executive actions like unwinding incentives, excessive severance benefits, conventional options, and repricing.

To treat the cause of excess executive pay, corporate governance must be addressed.  More specifically, boards must be made more dependent on shareholders for reelection. Currently, several barriers exist for shareholders to remove a board member and replacing them with shareholder approved candidates. Significant time and money must be contributed as well as meeting a list of criteria such as ownership requirements.  

Placing new shareholder candidates shouldn’t require a vote or a year long wait.  In addition “short slates” should be replaced with “long slates” in order to have the majority of the board shareholder approved.  Providing challengers with some financial resources would remove advantages existing board members have. 

Removing these barriers would greatly improve the legitimacy of board decisions.  Most importantly, it would produce strong incentives for the board to make decisions with the shareholders best interests in mind.

Pay without Performance: Review

Bebchuk and Fried present a tight, persuasive argument demonstrating how managers utilize their power to extract rents and decouple pay from performance.  The structure of the book strengthens their message as it cover a broad range of topics yet transitions smoothly from point to point.  They begin by highlighting what arm’s length bargaining is supposed to portray, then describe what actual bargaining resembles, and demonstrate how their theory actually fits reality. The heart of the book documents how pay is decoupled from performance on account of managerial power. They finish by tying everything together through recommendations for ways to move forward.

Pay without Performance is an excellent resource for anyone who wants to learn more about executive compensation and/or corporate governance relationships between executives, boards, and shareholders.  The authors utilize minimal jargon and provide examples of concepts that might be hard to understand for readers with little financial background. The book might be out of range for the non-financial reader but if supplemented with other sources, the message is digestible.  A beginner and certainly an intermediate finance student would benefit from the amount of detail presented. Although the book lacks visuals and author calculated statistics, the authors have completed a thorough literature review, compiling study after study to support their claims.  It is the wealth of empirical research that makes the book so persuasive. 

This book has the potential to appeal to heterodox and orthodox schools, as Bebchuk and Fried draw from both perspectives.  On the orthodox side, the authors give incentives the primary role in executive and board decisions.  At times, they employ the concept of utility to discuss why one pay package might trump another. Throughout the book, they heavily rely on the concept of efficiency to explain company actions. 

The discussion of power is not something usually found in orthodox financial economics.  Bebchuk and Fried not only acknowledge executives hold power, but also actively use it to extract rents and insulate themselves against their own poor performance.  Once garnered by managers, power can be used to accumulate more power and thus further protect themselves from changes or reforms not in their best interest.  Psychological effects have a substantial role to play in the relationship between directors and CEOs.  The authors pull from behavioral finance by offering social and psychological reasons for the board’s loyalty to the executives and not shareholders. 

Bebchuk and Fried approach executive compensation holistically and extensively.  By not exclusively invoking orthodox or heterodox perspectives, they paint a robust picture of executive compensation.  Incentives and efficiency are just as important as power and psychology.

That said, they inspect and challenge executive compensation only in the interest of fair process.  The authors separate their argument from the moral argument at the very beginning and openly consent to higher CEO pay as long as the bargaining carried out follows the arm’s length model.  By separating themselves from moral concerns, their argument gains objectivity at the cost of leaving other stakeholders like regular employees and the community out of the picture.

The authors repeat the scope of their book and challenging the level CEO pay or the distribution of earnings is not within it. They do no discuss how CEO compensation for good performance is untangled from the rest of the employee’s contributions. Nor is there a conversation about how communities are better off when CEOs engage in arm’s length bargaining.  Although narrowing the scope of their book has allowed Bebchuk and Fried to completely and robustly dissect executive compensation on a micro-level, it has in effect excluded how executive compensation fits into the big picture.  What they call for is fair process and once it is obtained, in their eyes, the battle is over.

Future research could widen the authors’ message to include more of a general dialogue about CEO pay and statistics. Further research could also connect this literature to the growing radical literature on maximizing shareholder value – how stock buybacks are increasing shareholder wealth and how that impacts executive compensation. 

This book is a thorough introduction to executive compensation involving analytical tools from both heterodox and orthodox schools.  The authors utilize a fascinating array of studies to demonstrate how executives use their power to extract rents and receive pay that does not relate to their performance.  Even though the scope of the book does not provide space to challenge the level of CEO pay, question how much company success is because of CEO decisions, or how executive compensation affects social welfare, it is a conservative place to start in critiquing executive compensation and well worth a read.