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Bank Ceo Incentives Were the Major Factor in Credit Crisis

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Submitted By jaya6192
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TABLE OF CONTENT | PAGE | | 1.0 | Introduction | 1-2 | | | 1.1 | Bank CEO incentives | 2 | | 1.2 | Credit Crisis | 2 | | | | | 2.0 | Bank CEO incentives were the major factor in credit crisis | 2-5 | 3.0 | Conclusion | 6 | | | | 4.0 | References | 7 |

1.0 Introduction

Bank CEO and the credit crisis was it related to each other? There is a statement which is ‘Bank CEO’s incentives were a major factor in credit crisis.’ First of I would like to explain a few terms in the topic. A CEO stand for Chief Executive Officer meanwhile, incentives here doesn’t only mean money or material incentives. It also includes motivation either positively or negatively towards the CEO. Therefore, the statement says that the lack or abundance of incentives to the CEO is the major factor for the past credit crisis. CEO incentives were not the major cause for the credit crisis based on my research from the journals and articles. I totally oppose these because I have gathered valuable evidences from journal and articles that I have read online.

1.1 Bank CEO Incentives

There are several titles for the position Chief Executive Officer (CEO) such as Managing Director, Executive and President. The responsibility of CEO is different from one another according to their size, scope of work and an organization. CEO plays an important role by making a decision, hiring of staff. Besides that, CEO will have communication deal with board of directors and corporate operation of high strategy in large company. CEO incentives are given based on the CEO’s performance up to their level of achievement. Incentives are generally rewarded by cash or stock. They also compensated with some other benefits or increment in salary.

1.2 Credit crisis

Credit crisis defines when an unexpected recession in accessibility at high-risk loans or credit that begin to default. In this credit crisis, either bank does not receiving enough interest on loan or securitized loan had been paid too much. This occurs when some of the factors combine in the marketplace by affecting investors. Credit Crunch also known as credit crisis. For example, bank will charge interest rates on loans, but when the first installment payment is low, they become too high borrowers to pay. If borrowers failed to pay on loan, then the loan value simultaneously will drop/decline.

2.0 Bank CEO’s incentives were a major factor in credit crisis

Journal of Financial Economics by Rudiger Fahlenbrach and Rene M. Stulz has a lot of evidence that the credit crisis were not due to the CEO incentives. Based on the Financial Economics Journal, Alan Blinder said that poor incentives are one of the fundamental causes for the credit crisis. Even so, there is no evidence to support Alan Blinders statement. There is also no supporting evidence that banks with better compensation with CEO interest with shareholders having higher stock return during credit crisis. The opposite seems to have a more evidence which is that banks led by CEO whose interest was better aligned with the shareholders had worse stock returns and even worse return on the equity. Other option such which is also involved is excessive risk-taking. No evidence has been found that bank returns were lower if the CEO had a higher incentives or cash or materialistic bonuses.

There is a lot of version on poor incentives explanation of the credit crisis. First, CEO was given strong incentives to focus on the short term run of the bank instead of the long term run. The second version is, option compensation gave incentives to CEO to take higher risk than the optimal risk for shareholders. The third version is, high leverage of financial institutions implies that increase in the volatility of assets is made by the CEO because the shares are effectively options on the value of the assets. Incentives given to the CEO can make them concentrate more on the short term run which leads to higher risk taking and choose excessive leverage and has no clear means that the CEO incentives in banks had these implications.

Besides that, CEO’s mindset left them no other choice than focusing on short term run to maximize their banks business aggressively for the fear of losing their job if unable to develop their bank. CEO might have chosen subprime securitization business due to the fear of the market would react negatively towards the slow growth even if the shareholders would gain more benefit in the long term run from the absence of the poor growth. In comparison, if the CEOs have proper incentives following along with the market needs and the CEOs principle to concentrate more on the long term run consequences of their actions. CEO might be focusing more on the cash bonuses rather than potential increase in their equity wealth which is not realizable until it’s too late.

Basically, giving options to the CEO’s wealth may also affect the willingness of the CEO to take risks. This evidence can be found in Ross 2004 journal. Higher sensitivity of CEO wealth to volatility will make the CEO’s and shareholders interest better aligned to one another and may depend on many considerations. As an example, if the CEO’s stock holdings makes him conservative or passive, greater sensitivity of his wealth volatility would help in assisting the alignment of CEO incentives with those of the shareholders. We dint find any evidence that non-CEO executives during the end of 2006 are related to the later bank performance during the credit crisis. However, if we take a look at the total incentives of the first five or top five executives, we find that our results on CEO incentives were robust to this alternative specification.

It is found that from Crawford, Szell and Miles (1995), deregulations, pay-for-performance sensitivity of CEO pay increased more at less well capitalized institutions. They interpreted that this is the result of moral hazard problem which was induced by the emergence of deposit insurance prized in a certain way which does not reflect the risks taken on by individual banks. John, Mehran and Qian 2008 are an example of leveraged institutions. These article oppose that leverage should reduce the pay-for-performance sensitivity of bank CEOs in comparison with other CEO because the monitoring is done by debt holders. Following that, article of John and Qian 2003 defines that bank CEOs have even less pay-for-performance sensitivity than any other CEOs.

An investigation has been done between CEO incentives during the end of the fiscal year 2006 and the bank performance during the credit crisis. They have taken into consideration the bank returns from 1st of July 2007 to 31st of December 2008 to measure the corresponding returns of banks during the credit crisis period. The recession did not end up in year of 2008. As a result, they consider banking section suffered in losses. Before the crisis, it is not clear how it impact on the bank stocks will affected by incentives of CEO.

Furthermore, they had tried to describe short term and equity incentives as a first measure. As the 2nd and 3rd method to explain the equity risk of Bank CEOs as per below,

R¨ udiger Fahlenbrach , Rene´ M. Stulz p 11-26, 2011,

“….study the ratio of cash bonus to cash salary to gauge short-term incentives. The equity incentive measures are dollar gain from +1% and percentage ownership. The equity risk exposure is measured by dollar equity risk sensitivity and percentage equity risk sensitivity. In Regressions 6 through 9 respectively, we use cash bonus, dollar and percentage equity incentives, and dollar and percentage risk exposure measures, and we control for other determinants of performance measured as of the end of 2006. In Regression 6, the dollar gain from the +1% measure has a negative significant coefficient.”

Their evidence above prove that CEO incentives definitely cannot be blamed for the credit crunch or bank performance during crisis period. If we have deep look into at larger sample such investment bank as well, there is no evidence has been proven that CEOs performance bad during the credit crisis as their incentives is less. They also explain the CEO had poor compensations based on bank performances. As an example from the sample, stock option or cash bonus to be reason on bank performance during the recession. As result from their investigation, they found that the relationship and bank performance is no difference between Troubled Asset Relief Program (TARP) and non-TARP banks.

Most of researchers have found that high level of incentives of CEO leads them to take risk in banking industry. For example, Chairman Ben S. Bernanke said “compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability. In addition, Belkhir and Chazi (2010), found evidence that incentive pay leads to greater opportunity and even to take risk as well.

In nutshell, researchers found that Bank CEO incentives pay increased as always were deregulated.
Although they found the understanding of Bank CEO compensation, none of these studies has not focused on Bank CEO compensation were major factor of credit crisis. Violeta Diaz analysed by influences in CEO pay using a sample of large bank of America. He indicates that,

“ the measure of CEO incentives pay used is the sum of annual options and bonuses divided by total compensation. The sample covers the period surrounding the 2008 banking crisis. The evidence generally suggests that bank size, equity to assets, growth opportunities, recent share performance, and the existence of powerful outside shareholders are positively related to CEO incentives”

This study found that, influence of outside shareholders decreased simultaneously after the
Height of banking crisis. Authors also indicate top management ownership does not influence the bonus or pay. According to TARP, funds does not affect or influence bank CEO incentives pay. In prior 2008, incentives pay has no influence in perception of bank. The perception significantly decreases incentives pay during the peak of the crisis. Since this research indicates that Bank CEO incentives were not major factor for credit crisis.

3.0 Conclusion

4.0 References

* Bank CEO incentives and the credit crisis René Stulz, Ohio State University Fisher College of Business, on Thursday August 6, 2009

* The credit crisis around the globe: Why did some banks perform better?
Andrea Beltratti and René M. Stulz

* Excessive Bank CEO Pay and Financial Crisis
G. Nathan Dong* June 14, 2013

* Bank CEO Incentives and the Credit Crisis Rüdiger Fahlenbrach and René M. Stulz*

* Bank CEO incentives and the credit crisis R¨ udiger Fahlenbrach a, Rene´ M. Stulz b,c,d,n Journal of Financial Economics 99 (2011) 11–26.

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