Remove the Risk Incentive from Bankers' Pay

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by Jennifer Carpenter and Ingo Walter

Nothing about the financial crisis has done more to outrage the public and fuel reform than the drumbeat of bankers' pay announcements. Pay levels at Wall Street's top 25 banks reached a record high of $135bn last year, with employees' share of revenue rising to 32.5 per cent. While shareholders may have reason to object, the real concern for regulators and taxpayers on the hook for the next bail-out is not the level of pay, or how profits are divided between employees and shareholders, but rather the risk incentives that bank pay creates.

Reports of increased use of deferred compensation are cold comfort if it is in the form of stock, because as long as government guarantees are underpriced, the value of the stock increases with the bank's risk and leverage, so employees and shareholders are aligned in their incentives to ramp up risk. The Securities and Exchange Commission has just proposed to curb risk appetite by regulating bankers' compensation directly, requiring top executives at large banks to defer at least 50 per cent of incentive pay for three years. Regulators would do better to tackle the problem at its source, by setting deposit insurance premiums and taxes on other financial groups commensurate with the level of systemic risk they generate, and taking the risk appetite out of the equity itself.

Read the full opinion editorial in the Financial Times

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The Dodd-Frank Act, signed into law in July 2010, represented the most significant and controversial overhaul of the U.S. financial regulatory system since the Great Depression. Forty NYU Stern faculty, including editors Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, and Ingo Walter, provide a definitive analysis of the Act, expose key flaws and propose solutions to inform the rules’ adoption by regulators, in a new book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Wiley, November 2010).

About Restoring Financial Stability

Previously, many of these faculty developed 18 independent policy papers offering market-focused solutions to the financial crisis, which were published in a book, Restoring Financial Stability: How to Repair a Failed System (Wiley, March 2009).

About the Authors