"Gender-Compensation Differences Among High-Level Executives in the United States" 

Industrial Relations: A Journal of Economy and Society, Vol. 49, Issue 3, pp. 346-370, July 2010

FERNANDO MUÑOZ–BULLÓN, affiliation not provided to SSRN

Bertrand and Hallock (2001: 3) present compelling evidence that female executives in the United States earned 45 percent less total compensation than their male counterparts for 1992–1997. We complement their results by analyzing data over a longer time period and, more importantly, contend that most of the unexplained gender difference in total pay among executives was due to gender differences in the portion of variable pay, in particular a different cash payout from stock option exercises.

"What do CEOs Realize from Option Pay?" 

MARK C. ANDERSON, University of Texas at Dallas - Department of Accounting & Information Management
Email: andersmc@utdallas.edu
VOLKAN MUSLU, University of Texas at Dallas - School of Management
Email: vmuslu@utdallas.edu

We investigate how the proceeds CEOs realize from exercising stock options compare to the total nominal value of option pay that they receive during their tenures as CEOs. For a large sample of CEOs who completed their tenures during the period from 1992 to 2007, we find that the proceeds realized from exercising options were less than 50% of the nominal value of option pay, with the unrealized difference corresponding to almost 30% of total compensation. In contrast to the sensitivity of nominal option pay and option value to firm performance emphasized in prior literature, this under-realization reflects the precarious nature of the CEO position and the less publicized sensitivity of option compensation to factors that influence CEO turnover and option forfeiture or involuntary exercise. We also find that under-realization of option pay is proportionately greater for CEOs hired from outside the company, partially explaining higher nominal pay for these CEOs.

"Executive Compensation and Risk Taking" 

FRB of New York Staff Report No. 456

PATRICK BOLTON, Columbia Business School - Department of Economics, Centre for Economic Policy Research (CEPR), National Bureau of Economic Research (NBER), European Corporate Governance Institute (ECGI)
Email: pb2208@columbia.edu
HAMID MEHRAN, Federal Reserve Bank of New York
Email: Hamid.Mehran@ny.frb.org
JOEL D. SHAPIRO, University of Oxford - Saïd Business Schoo
Email: Joel.Shapiro@sbs.ox.ac.uk

This paper studies the connection between risk taking and executive compensation in financial institutions. A theoretical model of shareholders, debtholders, depositors, and an executive suggests that 1) in principle, excessive risk taking (in the form of risk shifting) may be addressed by basing compensation on both stock price and the price of debt (proxied by the credit default swap spread), but 2) shareholders may be unable to commit to designing compensation contracts in this way and indeed may not want to because of distortions introduced by either deposit insurance or naive debtholders. The paper then provides an empirical analysis that suggests that debt-like compensation for executives is believed by the market to reduce risk for financial institutions.

"Executive Compensation and Corporate Governance in Financial Firms: The Case for Convertible Equity-Based Pay" 

Columbia Law and Economics Working Paper No. 373

JEFFREY N. GORDON, Columbia Law School, European Corporate Governance Institute (ECGI)
Email: jgordon@law.columbia.edu

Unlike the failure of a non-financial firm, the failure of a systemically important financial firm will reduce the value of a diversified shareholder portfolio because of an increased level of systemic risk. Thus diversified shareholders of a financial firm generally internalize systemic risk whereas managerial shareholders and blockholders do not. This means that the governance model drawn from non-financial firms will not fit financial firms. Regulation that limits risk taking by financial firms can thus provide a benefit, rather than necessarily impose a cost, for the typical diversified public shareholder. Managerial shareholding also gives rise to particular problem of the CEO who, despite the increasing precariousness of the firm’s position, may be reluctant to pursue equity infusions or to sell the firm because of the consequent dilution of his ownership stake. This might be called the “Fuld problem.” To mitigate excessive risk-taking both in ordinary operations and as the firm approaches financial distress, the paper proposes a new compensation mechanism for senior managers, convertible equity-based pay. Upon certain external triggers, such as a downgrade into a high risk category by regulators or a stock price decline of a particular percentage, such stock-based compensation should convert into subordinated debt, at a valuation discount. This will give managers an incentive to curb excessive risk-taking and in particular to steer the firm away from financial distress.

"Moving Beyond the Dodd-Frank Act: Reducing Systemic Risk by Cooling Wall Street's Bonus Culture" 

BERNARD S. SHARFMAN, Independent
Email: bsharfman@CMHT.com

The financial sector has a natural tendency to develop business models which may implode over time, potentially creating systemic risk. Examples of such models are not hard to find. In the early 1980s, savings and loan institutions and Fannie Mae suffered large losses because of a business model that relied heavily for its success on the existence of an upward sloping yield curve; in 1998, the collapse of Long-Term Capital Management resulted from unexpected sharp movements in bond prices, an overreliance on extreme financial leverage and on financial models that underestimated the probability of rare events; and in 2008, AIG and other market participants fell victim to the sudden illiquidity of securities backed by residential mortgage loans. Therefore, if Congress truly wants to minimize the financial sector’s systemic risk, it needs to look at ways to discourage or at least not provide incentives that encourage the financial sector’s tendency to create unsustainable business models.

The premise of this article is that the financial sector’s tendency to create unsustainable business models can be at least partially explained by the sector’s desire to pursue fake alpha (appearing to create excess returns but in fact taking on hidden tail risks, which produce a steady positive return most of the time as compensation for a rare, very negative, return).

The pursuit of fake alpha is encouraged in the financial sector by a compensation system that focuses on large annual bonuses. This is especially true on Wall Street, the creative heart of the financial sector. While such bonus compensation arrangements encourage participates to come up with creative ways to allocate capital, they also encourage them to seek out creative new ways to pursue fake alpha, without regard for the risks that these strategies create for the institutions that employ them or for the financial sector in general.

Like air and water pollution created by industrial firms, systemic risk created by Wall Street employees is a third-party cost or externality which needs to be internalized by the firms that produce it. Based upon the lessons learned from the financial crisis of 2008, this systemic risk results from inadequate risk management at the firm level. As demonstrated by the AIG example, financial firms are not able to adequately internalize the firm-specific financial risk created by their employees’ pursuit of fake alpha, creating a significant source of counterparty risk and in turn a key source of systemic risk. This inadequacy is created by the perfect storm of a strong bargaining position possessed by these employees in combination with a strong bonus culture and the inability of executive management to control the pursuit of fake alpha.

As a remedy, this article advocates the use of tax policy to cool this bonus culture. More specifically, what is recommended is a new tax that would be similar in approach to Internal Revenue Code section 162(m), but with a much greater reach as it would be applied to all employees who work for a financial sector firm.

"Wolves in the Hen-House? The Consequences of Formal CEO Involvement in the Executive Pay-Setting Process" 

GLENN BOYLE, University of Canterbury - Economics and Finance
Email: glenn.boyle@canterbury.ac.nz
HELEN ROBERTS, University of Otago - Department of Finance and Quantitative Analysis
Email: hroberts@business.otago.ac.nz

New Zealand ?rms exhibit signi?cant variation in the extent to which they formally involve CEOs in the executive pay-setting process: a considerable number sit on the compensation committee, while others are excluded from the board altogether. Using 1997-2005 data, we ?nd that CEOs who sit on the compensation committee obtain generous annual pay rewards that have low sensitivity to poor performance shocks. By contrast, CEOs who are not board members receive pay increments that have low mean and high sensitivity to ?rm performance. Moreover, the greater the pay increment attributable to CEO involvement in the pay-setting process, the weaker is subsequent ?rm performance over one, three- and ?ve-year periods.

"Cash-Based Executive Compensation and Net Earnings – Ethical Analysis in Light of the Financial Crisis of 2008" 

MICHAEL A. SANTORO, Rutgers Business School-Newark and New Brunswick
Email: msantoro@business.rutgers.edu
RONALD J. STRAUSS, Rutgers Business School - Newark and New Brunswick
Email: rjstraus@pegasus.rutgers.edu

This article examines a particular form of executive compensation, to wit executive incentive compensation paid in cash, a compensation practice susceptible to particular forms of moral hazard and conflict of interest. Beginning in 2007 and continuing throughout 2008 and 2009, many firms in the financial services industry incurred enormous losses while in the years immediately preceding this deluge of losses many executives received substantial cash-based compensation. This substantial divergence of economic outcome between shareholder and executive is the focal point of the analysis here. We examine, under several forms of moral reasoning the payment of cash-based incentive compensation in the financial industry and in each case cannot find moral justification for such practices. Further, such practices create moral hazard, conflicts of interest, and unjust outcomes. Cash-based incentive compensation is largely based upon measures of short-term earnings; earnings which may not fully reflect substantial risk taking, the outcome of which remains uncertain at the time that risk-free cash bonuses are paid.