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Executive Compensation at Financial InstitutionsExecutive compensation at U.S. companies has become dramatically disproportionate relative to the average workers at those companies over the past 25 years. Now, the current global financial crisis is putting a harsh spotlight on executive compensation at financial institutions in particular. This report looks at the basic nature of executive compensation packages and the issues or concerns that have been raised about them. That information provides a context for looking specifically at financial institutions: what makes their executive compensation programs different and how the current financial crisis is going to affect those programs.

Executive compensation refers to the mechanism that corporations use to pay their senior executives. Publicly traded companies are required by the Securities and Exchange Commission (SEC) to report and explain compensation paid to these senior executives. Senior executives usually include the CEO, CFO, and three other highest-paid employees identified in a company's financial reports. These executives are the primary operational agents for shareholders hired by the Board of Directors and employed to lead the firm.

Companies attempt to structure their executive compensation packages to recognize the special role played by their CEOs and other executives as the public leaders of the companies. Executives act as operational agents for shareholders of a company, so executive compensation is structured to offset a potential agency problem. In essence, this agency concept refers to the supposition that senior executive officers of companies with numerous stakeholders will act in their own best interests to maximize personal gains before the interests of the many other stakeholders of the firm, in the absence of proper controls.

To address this agency problem with company executives, executive compensation plans rely heavily on bonuses and incentives that are tied to how well those executives lead the company to generate greater shareholder wealth. However, executive compensation has exploded since 1980 both in absolute dollars and in relationship to compensation of other company employees. Publicity about extreme cases has triggered anger and potential legislation to change how executive compensation works and constrain how much executives are paid. There is heightened sensitivity now to apparent excessive executive compensation at financial institutions, focusing on ones being bailed out of trouble with taxpayer dollars. As a result, the U.S. federal government is actively changing executive compensation at financial institutions.

A compensation package is put together to address multiple objectives: attract talented employees, retain employees who perform well, and focus employees on contributing to the success of the company. Especially in the case of executive compensation packages, those packages must recognize the special public leadership role provided by executives and must ensure that the company and executive interests are aligned. Executives are agents for the owners of the firm and to avoid any agency problem of conflicted interests their compensation packages are carefully crafted, trying to induce and reward high performance and success for the firm. High performance is usually associated with generating shareholder wealth.

Base salary is the fixed portion of executive compensation usually determined by using salary surveys and analyzing pay at market peer companies. Variations relate to previous experience and demonstrated skills. For corporate executives base salary is defined in an employment contract and thus not tied to performance. Because salary is fixed, other components of a compensation package often are expressed as a function of base salary. For example, a target annual bonus may be set at some percentage of base salary.

An annual bonus provides a variable payment to the executive that is only paid when specified performance measures reach pre-defined thresholds. The bonus payment is usually cash and the performance measures reflect important aspects of corporate performance, although sometimes measures relate to individual performance. No payment is made unless the performance measure reaches a minimum threshold at which point

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a minimum percentage of the target bonus is paid. The bonus payment can increase up to some maximum payment corresponding to the performance measure reaching some cap or maximum level.

An example bonus plan might be to pay a target bonus of 30% of base salary if the firm achieves earnings per share of a set amount. The minimum performance threshold might be 85% of the performance target and pay at 85% of the target bonus. Similarly, the maximum threshold and payment might be set at 110%. The Board of Directors' choice of performance measures and target results expresses the corporate goals the executive agent should be trying to achieve for the company's shareholders.

Long-term incentives award an executive with corporate equity in the form of stock options and/or restricted stock. Stock options vest over multiple years (usually 3 to 5 years), with incremental percentages of the stock becoming exercisable (tradable) over the years. Stock options are only valuable if the stock price rises over time. Restricted stock is granted (given to the executive without paying for them) with constraints such as requiring them to be forfeited if the executive leaves the company within a certain time period (at least 3 years). In both cases, the executive is encouraged to stay with the company and to ensure that the company sustains good performance. Long-term incentives in the compensation package directly tie the interests of the executive to the interests of shareholders by making the executive a significant shareholder as well.

Perquisites (often referred to as perks) are benefits provided to the executive. These perks include standard employee benefits plus extra fringe benefits such as extra insurance, memberships in special clubs, and special transportation privileges. This is usually a small portion of the compensation package, 2% to 3%. Perks are intended to expedite the executives work efforts such as using club memberships to entertain customers or fly on a company jet to reduce total time away from the office.

Severance agreements are a common component of an executive compensation package, especially when an employment agreement is in place. A severance agreement spells out payments to be made to the executive upon leaving the company involuntarily without cause such as when a company is sold or merged and changes control of the firm. This type of agreement is often referred to as a "golden parachute" and typically consists of payments of two to three times annual base salary and bonuses plus certain benefits. A severance agreement intends to encourage executives to be objective during takeover or merger situations.

The SEC has had regulations in place for many years that require executive compensation to be presented in a firm's annual report and proxy statement, plus Form 10-K filings. These rules try to limit asymmetric information problems by having all publicly traded companies uniformly and consistently report the compensation of senior executive officers. The rules have expanded over the years in an attempt to make compensation more transparent and clear to investors and shareholders. Historically, the Board of Directors sets executive compensation often with the help of paid compensation consultants and initial recommendations from corporate management. The SEC requires that the outside board members (not firm employees) vote to approve executive compensation.

Executive compensation is a concern of shareholders specifically and of the public in general. Shareholders rely on the firm's executives as the shareholders' key operational agents running the company, plus shareholders pay the firm's executives out of funds that otherwise would become profits. The general public has been especially concerned about executive compensation since 1976 when modern financial analysis began looking at managerial power as an agency problem.

Apparent excesses in executive compensation and dramatic growth since 1980 combine with publicized abuses to draw ever more attention to executive compensation amounts and practices. In 1980 the ratio of CEO total compensation to average pay for hourly workers was 42 to 1. By 2008 that ratio dramatically rose to 344 to 1. The bull market of the 1990's coupled with heavy use of stock options for long-term incentives to drive up this ratio. Changes in executive compensation have tracked the S&P 500 index (representing changes in stock

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prices), but does not track closely with corporate profits. This phenomenon matches recent research findings of Gabaix and Landier, whose model of CEO pay shows that the dramatic growth in CEO pay from 1980 to 2003 is fully attributable to the growth in market capitalization of large companies for that period.

The dramatic difference between CEO compensation and pay for normal workers is very hard for those normal workers to understand or accept. A survey of 2701 companies in 2007 found that the median total compensation for CEOs was $2.5 million, but CEO total compensation for the 30 highest paid CEOs in 2007 was between $40 million and $322 million per year. And, in 2008, the average compensation of CEOs for the 500 firms in the Standard and Poor's 500 (S&P 500) was $10.5 million per year. These huge numbers generate public anger, especially among normal workers facing job losses and financial hardships. When companies do not perform well for shareholders, then an agency problem is exposed suggesting that executives are not pursuing the interests of the firm's owners as strongly as they pursue their own interests.

There are flaws in implementation for each component of executive compensation, at least in select cases. Many companies have performed reasonably well over the years and pay their executives between 1% and 2% of annual returns to shareholders - an acceptable amount. However, excessive or extreme situations are easy to establish and generate negative publicity for underperforming companies during the current financial crisis. Setting base salary can be problematic given that the SEC requires public disclosure for executive pay. Competitive executives use the public information to negotiate higher salaries. This is further exacerbated by published salary surveys that are used by companies and compensation consultants. This situation implies that the SEC's efforts to limit asymmetric information have led to salary escalation.

Bonus payments have shown no significant correlation to executive performance. Relatively short-term annual bonuses tied to accounting measures can be easily manipulated for short-term effect. Stock options as a long-term incentive showed their flaws with the windfalls for executives that resulted in the 1990's when stock prices rose dramatically due to industry and market trends, unrelated to executive performance. This windfall effect is not filtered out to ensure a true reward for good performance by the executive. Perks have little to do with executive performance and instead serve to separate and potentially isolate top managers from the rest of the employees. A December 2008 survey by Watson Wyatt found that 21% of firms polled are reducing or eliminating perks.

Severance agreements are useful to keep executives open to appropriate merger and acquisition opportunities, but extreme versions are golden parachutes drawing negative attention to this component of compensation. In 2007 CEO severance packages at the top 200 publicly traded companies averaged $38.4 million. One extreme case in 2007 occurred when Home Depot's CEO, Robert Nardelli, was fired and left the company with $210 million. The situation with Nardelli at Home Depot also highlights a flaw in severance packages that are triggered even with the executive is asked to leave even when there is no change of control due to acquisition or merger.

Abuses in executive compensation increase both shareholder and general public concern with what compensation packages pay out, how they are established, and how they are implemented. The U.S. House of Representatives undertook a study in December 2007 to evaluate the conflict of interest involved when compensation consultants advise firms and their Boards of Directors. The study found that out of the 250 largest publicly traded companies in the U.S., 113 firms received compensation advice from consultants that generated significant revenue from these firms for other consulting services. The conflict of interest was pervasive and the resulting level of CEO pay at the companies using conflicted consultants was 67% higher than the median compensation at the other firms.

Another abuse of the compensation system for executives is highlighted by the 2006 stock options scandal where over 100 corporations were investigated by the SEC for back-dating stock options for their executives. Back-dating involves changing the date used to set a lower exercise price of stock included in the option. The

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payout for executives comes at the expense of shareholders. Stock options are intended to align executives with the interests of shareholders, but in this case the executives were acting in their own interests.

Executive compensation at financial institutions is roughly the same as in other industries. The 2007 study by the Wall Street Journal and the Hay Group compared industries for how compensation is split up within a package. The average split over all business categories was 18% salary, 24% bonus, and 58% long-term incentives. For financial institutions the split was only slightly different: 14% salary, 29% bonus, and 57% long-term incentives. There were 55 financial firms included in the study out of 417 companies overall. The main difference is in the heavier use of variable pay through bonuses. Earnings are the significantly predominant performance measure used to determine bonuses in financial firms. This is the predominant performance measure used in other business categories.

Although executive compensation is implemented similarly at financial institutions as it is at other businesses, the special nature of banks and other financial institutions should be reflected in a variation in their compensation plans. In recent testimony before the U.S. House of Representatives Committee on Financial Services, Lucian Bebchuk identified an important distinction in executive compensation at financial institutions. His point was that the financing structure of these firms and their compensation packages lead to excessive risk-taking. Specifically, Bebchuk suggests that incentives are tied to "a highly leveraged bet on banks' assets."

Bebchuk argues that tying executive compensation heavily to bonuses and long-term incentives that relate predominantly to accounting measures (such as earnings) reflects the interests of common shareholders and ignores the interests of other important stakeholders of financial institutions: preferred shareholders, bondholders, and depositors. A broader set of metrics to drive appropriate incentives for bank executives are needed. Using bonuses and incentives to prevent any agency problems with executives at financial institutions is flawed by concentrating only on common shareholders and stock price.

Executives at financial institutions are not the highest paid executives relative to other U.S. businesses and financial firms are not the only ones with compensation packages that anger employees, shareholders, and the general public. However, the current financial crisis has put a spotlight on these executives, especially the ones receiving funds from the U.S. government. Examples from 2007 of extreme compensation amounts within the financial firms included Goldman Sachs CEO Lloyd Blanfein getting $54 million per year and J.P. Morgan Chase CEO James Dimon getting $30 million per year. In comparison to these packages, Countrywide Financial CEO Angelo Mozilo received $102 million in 2007 before that company was acquired by Bank of America and Mozilo was charged by the SEC with insider trading and securities fraud.

One result of the current financial crisis is lower total compensation for CEOs; CEO compensation dropped by 15% in 2007 and 11% in 2008 (IOMA, 2009). Much of the drop in pay is due to lower performance (lower profits) by the CEOs' firms which affects bonuses and stock option (or restricted stock) valuations. In 2008 financial institutions' CEOs experienced a 43% drop in pay - significantly more than the average overall.

According to the National Bureau of Economic Research (NBER), the current U.S. recession began in December 2007. One of the drivers of this situation was losses and write-downs that banks and other financial institutions incurred by holding asset-backed securities (ABS) - in particular, non-prime mortgage-related ABS. The prices of ABS of this nature dropped significantly following a rise in mortgage defaults and foreclosures, which was a result of falling house prices and a weakening economy.

There has been a high level of complexity in the events surrounding this recession, but the majority of the focus has been on the financial sector. Due to the significant losses on ABS such as those that were created from pools of subprime - now seen as "toxic" - loans, bank failures were on the rise. The investment banking business essentially ceased to exist in the U.S., at least in its current form, as companies like Bear Stearns and Lehman Brothers filed for bankruptcy, Merrill Lynch was acquired by Bank of America, and Goldman Sachs

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and Morgan Stanley became bank holding companies. Exacerbating the economic downturn was the industry-wide decision of bank lenders to limit the credit supply. The plunge in-house prices was coupled with a 52 percent drop in the S&P 500 stock price index from October 9, 2007 to November 20, 2008, and an oil price shock.

Such shocks also slowed the demand for credit as a result of weaker future growth of income and profits. Unemployment has also reached dizzying heights for the U.S. Since December 2007, 2.6 million workers have been left jobless. Typically, the U.S. has an unemployment rate that is approximately half of that of its European counterparts. Now, the unemployment rate in the U.S. is nearly touching on low double digits.

In the current global business environment, markets and economies around the world have become much more interconnected. From an economic perspective, one could accurately assess this situation as strong positive correlations among such nations. This tying together of the world's economies is linked to global markets and international trade.

The U.S. recession has also had negative ramifications on its trading partners: according to the Economic Cycle Research Institute (ECRI) six of the world's seven major developed countries that make up the G7 are now experiencing a recession. Global gross domestic product (GDP), according to the International Monetary Fund, is expected to decline by at least one-half basis points - the first annual decline in world GPD in 60 years.

The simultaneous slowing in economic growth in most of the world's largest economies also had a negative impact on the U.S. economy as exports were a key source of U.S. economic growth in 2004-07. The "credit crunch," as media outfits described the current situation, has global implications because international investors are involved. There was a distribution of ABS composed of risky mortgages packaged and sold to banks, investors, and pension funds around the globe. These repackaged debt securities became much more sophisticated, as it was unclear how to define who owned the property, and the crisis really developed from the mis-pricing of the risk of these products.

The government response to this economic crisis was to provide about $1.1 trillion in new liquidity, as well as hundreds of billions of dollars in new capital for flailing institutions. The idea in Washington, D.C. was that declining house prices triggered a financial crisis that could be alleviated only through government action (Hall & Woodward, 2009). Both the Federal Reserve Bank (Fed) and the federal government supported a stimulus to help restore full employment and offset the recession by lifting house prices and the condition of institutions that are holding mortgages.

The U.S. Treasury Department (Treasury), under the guidance of former Treasury Secretary Henry Paulson, created the Troubled Asset Relief Program (TARP) to recapitalize a range of financial institutions through a series of quasi-permanent loans. It has invested in banks, AIG, and even one non-financial company, General Motors. TARP has been designed to add capital to the firms which receive a TARP injection because these firms do not have to pay it back until convenient. This program has been thought of as an important means of providing liquidity in the financial markets, as the added capital makes banks more willing to lend by reducingtheir fears of becoming insolvent due to an inability to meet their obligations should asset prices decline. Up to now, banks have hoarded liquidity to cover any losses they might experience on their own books.

Furthermore, the Obama administration has collaborated with Congress to create a fiscal stimulus program - the American Recovery and Reinvestment Act of 2009 (ARRA). The stimulus is well-diversified across the U.S. and has been distributed in the form of spending increases and tax cuts. The purpose of the tax cuts is primarily to reduce the cost of labor or improve incentives to work. Removing sales taxes and gradually bringing them back in effect has been an idea proposed in this legislation and would stimulate immediate consumption spending.

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On June 10, 2009, the Treasury issued an Interim Final Rule (IFR) in regards to executive compensation and corporate governance provisions of the Emergency Stabilization Act of 2008 (EESA), later amended by the ARRA. The IFR applies to firms that received or will receive financial assistance under the TARP and consolidates or overrides previous Treasury rulings on executive compensation. However, there are exemptions from certain provisions for TARP recipients that do not have outstanding obligations to the government.

Firms with outstanding TARP obligations are prohibited from paying or accruing any bonus, retention award, or incentive compensation to certain employees. Depending on the size of the TARP financial assistance, this may apply only to the single most highly paid employee. Larger firms have restrictions that apply to a greater number of employees. For instance, the highest paid employee is the only individual bound by this provision in firms receiving less than $25 million in financial assistance. The rule applies to the five most highly compensated employees of a TARP recipient receiving between $25 million to less than $250 million in financial assistance. Restrictions apply to a greater number of employees for TARP recipients receiving higher amounts of assistance.

Golden parachutes for senior executive officers of firms receiving TARP assistance are now prohibited; these senior executives typically include the principal executive officer, principal financial officer, and the three most highly compensated executives. Furthermore, a provision in the IFR allows firms to seek a recovery or "clawback" of any bonus, retention award, or incentive compensation paid or accrued to a senior executive or one of the next 20 highly compensated employees when payments or accruals were based on materially inaccurate financial statements or any other materially inaccurate performance metric criteria.

A compensation committee composed of independent members of the Board of Directors of TARP recipients must be established by September 14, 2009, if not already in existence. The IFR states three main purposes for the creation of this committee. The compensation committee must discuss, evaluate, and review executive compensation plans to ensure that there are no incentives to encourage taking unnecessary and excessive risks that could threaten the value of the TARP recipient. Secondly, a similar discussion, evaluation and review with senior executives will be made to prevent compensation plans from encouraging a focus on short-term results rather than long-term creation. Lastly, this process will be implemented in order to discourage the manipulation of reported earnings to enhance compensation. All three provisions protect the stakeholders of a firm, whether publicly traded or privately owned. In addition, Boards of Directors are required to offer "say on pay", a nonbinding shareholder vote on executive compensation.

Another important development in the IFR relating to executive compensation is a requirement for TARP recipients to develop an excessive or luxury expenditure policy. Such expenditures include: entertainment or events; office or facility renovations; aviation or other transportation services; or any other similar perks or events that are not reasonable for staff development, performance incentives, or other similar expenditures incurred in the normal course of business. This provision is implemented to prevent situations such as the executive officers of the Big Three carmakers who chartered private jets to Washington, D.C. to seek financial assistance from the government. Such spending excesses will be eradicated with the implementation of this IFR guideline.

The issue regarding executive compensation in industry has been an ongoing concern at least since the 1980s, as the pay differential between senior executive officers and those of "rank-and-file" workers continues to spread significantly, much to the dismay of the public at large. This paper looks specifically at this topic as it relates to the financial industry, paying special attention to the recent events leading to the current recession in the U.S. While many financial firms - and certainly all of the "bulge bracket" firms - have acted in aggregate in a similar manner to other businesses, more scrutiny is placed on this industry due to its direct involvement in the credit crunch and subsequent recession both domestically and in many partnering nations abroad.

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Executive compensation practices are undergoing significant reform driven by legislation and regulation changes directed at financial institutions. One of the main objectives of reform in executive compensation in the financial industry is to significantly improve on how compensation packages address the agency problem. To curtail this dilemma, federal legislation was enacted in June 2009 to closely regulate executive compensation in financial institutions, and others, who received funds from the federal government through the TARP. Specific rules differ based on the size of TARP assistance received. There is ongoing discussion of how best to adjust bonus and incentive compensation components to be more effective at aligning executive interests with all stakeholder interests, given the special nature of financial institutions. Every aspect of executive compensation is being addressed, including the elimination of golden parachutes (excessive severance packages) and excessive expenditures on perks.

New regulations and legislation, as yet unproven, have come into place predominantly to more effectively mitigate the agency problem in both the financial industry and other industries in general. Furthermore, these changes have developed as a political response to the outcry from the public. It remains to be seen how the financial industry will react to the changes, but the issue of executive compensation is likely to be highlighted in popular press as well as academic studies for the foreseeable future.

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