President Barack Obama's core policy on financial regulation is imposing constraints on risk taking at financial institutions that are "too big to fail":
... limits on the risks major financial firms can take are central to the reforms that I have proposed. They are central to the legislation that has passed the House, under the leadership of Chairman Barney Frank, and that we're working to pass in the Senate, under the leadership of Chairman Chris Dodd.
Fred Tung has just posted a paper in which he proposes getting at the problem via executive pay constraints:
Excessive risk taking by firm managers did not originate with the Financial Crisis of 2007-08. Though bankers had special incentives to take big risks in the period before the Crisis, the incentive effects of equity-based compensation have been understood for some time. Among other things, equity compensation tends to induce greater risk taking by aligning managers’ risk preferences with those of equity holders. Bankers’ equity-based pay structure at the time of the Crisis was a natural outgrowth of the pay-for-performance movement that began in the 1990s and now informs all of corporate executive pay. Longstanding government guaranties of bank liabilities additionally served to intensify bankers’ risk taking incentives.
I propose to ameliorate this gamblers’ incentive with a new approach to compensation at the largest banks, one that explicitly accounts for the possibility of excessive risk taking and incentivizes bankers against it. I propose that bankers be paid in part with their banks’ public subordinated debt securities. Market pricing of this debt will be particularly sensitive to downside risk at the bank. Including it in bankers’ pay arrangements and personal portfolios will therefore give bankers direct personal incentives to avoid excessive risk.
My approach has important advantages over recent banker pay reform proposals. The largest banks are owned and operated as wholly-owned subsidiaries of bank holding companies (BHCs), which also typically own other financial institutions. Two proposals—one by Lucian Bebchuk and Holger Spamann, and another by Sanjai Bhagat and Roberta Romano—would compensate bankers with BHC securities. But because BHCs own other institutions besides the given banking subsidiary, BHC securities can offer bankers only noisy and indirect incentives with respect to risk taking at the bank. My approach overcomes this problem by paying bankers with debt securities issued by the bank itself, a course unavailable with these other proposals. Debt securities of the bank will be much more sensitive to downside risk at the bank than the BHC equity and other securities that are the focus of these other proposals.
In addition, my proposal offers sufficient flexibility to enable the tailoring of banker pay to account for bankers’ existing portfolios of their firms’ securities and other claims on their firms. Because these portfolios typically dwarf bankers’ annual pay, they exert much stronger influence on banker risk taking than does annual pay. Compensation should therefore be structured primarily with these portfolio incentives in mind. My approach facilitates the tailoring of annual pay to achieve desirable portfolio incentives for bankers in a way that existing proposals cannot.
It's an interesting idea. As I've argued before:
We are in the mess we're in today in large part because some banks were thought to be too big to allow them to fail. Investors, depositors, and managers of these banks figured that the government wouldn't let them go belly up if they got into big financial trouble. They acted as though they were getting an implicit subsidy from the taxpayer. Accordingly, they acted as though some substantial portion of the risks they took were being externalized onto the taxpayer. In effect, they were betting that they could gamble with the taxpayers money, which meant they took on risks that they would not have taken if they were playing with their own money. As we know, they were right. They were deemed to be too big to fail, they got bailed out, and that created a precedent confirming that the taxpayer will always subsidize risk taking by big banks.
Assuming pay matters as much as the pay for performance crowd thinks it does (a subject for another day), cranking up management's exposure to downside risks should cause them to internalize those risks.
