Is Curbing Executive Pay Really the Answer?
“This is the problem at hand, and it does need a solution,” said Sam
Germaine, an associate at ETF Venture Funds who traveled from Philadelphia to
attend the Robert H. Smith School of Business
ThoughtLeadership@Smith series event on Executive Compensation and Public
Policy on September 18.
Lemma W. Senbet, the William E. Mayer Chair Professor of Finance, presented what he
coined the “dark side” and the “good side” of the issue of executive
The timing could not have been better. The Wall Street Journal
recently reported that a proposal put forth by the Federal Reserve would allow
the Fed to reject the compensation policies in all U.S. banks, with special
scrutiny of the largest 25. The proposal, according to the Fed, is intended to
reign in existing pay practices that might distort incentives for everyone from
chief executives to loan officers. The proposal does not require congressional
But the question is not, according to Senbet, whether executives are paid too
much. The question is how to structure compensation with sufficient incentives
for optimal performance, recognizing that optimal performance, by definition,
requires some level of risk.
In other words, Senbet said, “How can executive compensation be structured to
reward executives for good while also penalizing them for poor performance? Is
the pay-performance sensitivity too low? Do contemporary compensation contracts
promote a short-term outlook that encourage executive gaming? And do executive
stock options provide perverse incentives?”
Senbet, a world-renowned scholar in financial economics, offered some answers
to these questions.
“I am a very strong opponent of attempts to limit pay,” Senbet explained, as
he criticized public reactions and regulatory responses to the two landmark
events that have recently shaped society and the global business environment:
the burst of the information technology boom and ensuing corporate scandals
involving Enron, WorldCom and Adelphia, and the burst of the housing bubble and
the subprime debacle.
“While supporting the need to reform corporate governance mechanisms
influencing compensation setting, we should not support direct or indirect
efforts to legislate or regulate compensation levels and structures,” said
Instead, he proposed reforms in corporate governance that ensure compensation
committees are truly independent and have at least one financially literate
member, and enhancements in compensation disclosure that includes all elements
of executive compensation and exposes executives’ trading activities in the open
In addition, he proposed that FDIC rates be utilized to manage risk choices
by bank managers, and executive compensation can then be left to the bank
owners. Senbet recommends that bank executive compensation include the
appropriate balance of three components: a fixed salary, a fraction of the
equity of the bank, and a bonus.
“It’s a big world out there,” noted Dennis Horn, a partner at Holland and
Knight who attended the event. He asked if the U.S. could model its compensation
structure against any other countries or systems that might be doing it right.
Senbet suggested that any model should be based on components of other
countries’ practices, not a mirror of any existing system. He also cautioned
again against the U.S. imposing executive pay limits when other countries and
markets do not. “If they don’t but we do, we lose,” he said.
Senbet’s financial policy leadership role extends to advising government and
businesses. His outreach on this and other financial policy issues will expand
in the new Center for Financial Policy at the Robert H. Smith
School of Business. The Center launches on November 2, 2009, with a policy
roundtable on executive compensation.
Not coincidentally, the Center’s keynote speaker at that roundtable is none
other than Ken Feinberg, Obama’s pay czar—who, separate and apart from the Fed
proposal, is currently evaluating the proposed compensation packages for seven
companies that received "exceptional" assistance from the taxpayer-funded $700
billion bailout, including American International Group Inc., Bank of America
Corp., Citigroup Inc., General Motors, GMAC, Chrysler and Chrysler Financial.
For more information:
The ThoughtLeadership@Smith series presents Smith’s world-class faculty
discussing their latest research on topics of broad interest and importance, and
allows alumni, students and the business community to ask questions and network.
The series will continue this fall with two sessions in Washington, D.C. and
three in Baltimore.