Regulation of Executive Compensation and its impact on the stability of the financial system

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Introduction
In corporate circles, the financial crisis and its effect on companies is sometimes illustrated as a systematic phenomenon in which there is no individual responsibility. Public discussion, on the contrary often assigns the blame of the crisis to bankers or managers, and suggests conclusions of salary reductions or individual liability in terms of losses. In this paper the implications of executive compensation surrounding the financial crisis will be debated. Firstly, the types of executive compensation will be discussed and the implications of them. Secondly, how executive compensation contributed to the financial crisis will be conferred and thirdly the legal improvements and current process will be analysed. To aid understanding, articles and examples will be used to emphasise the various views of economists regarding executive compensation.

Non-Regulation of Executive Compensation
Executive Compensation can be described as the monetary bonus, or the non-monetary benefits which an executive receives for their work in an organisation. Executive Compensation can be a highly motivating incentive to work more efficiently, thus benefiting the organisation and keeping the executive content with his contribution and performance. However, this compensation can have adverse effects where the executive does not have the organisations best interest in mind, but his own in an attempt in maximise his compensation.
Executive compensation may consist of the following components, a base salary, incentive pay in the form of a bonus, stock awards, option awards. It may include a Supplemental Executive Retirement Plan (SERP) and extras such as cars and even club memberships. An executive could also qualify for deferred compensation earnings. Clearly the compensation can vary, due to the organisation, the executive position and some regulations set by the government. However some would disagree and say that executives in fact do deserve their compensation, due to the vast work hours, high stress and pressure of being in a top managerial position. This begs the question, should executive compensation be regulated?
An article “CEOs Deserve Their Pay” by Robert B. Reich uses quantitative data to reveal that, “According to research published recently by the Washington-based Institute for Policy Studies, the 20 highest-paid corporate executives earned on average $36 million in total compensation last year. The typical CEO of a Fortune 500 company earned $10.8 million, that's more than 364 times the pay of an average employee. Forty years ago, top CEOs earned 20 to 30 times what average workers earned.” This falls under the observation aspect of the empirical cycle, as Reich is following the trends of the pay that CEO’s receive. With the enormous increase in pay in the past half a century, many would argue that this is not fair, and their pay should be regulated, however Reich disagrees. Reich states that the change in pay is due to “a fundamental shift in the structure of the economy over the last four decades, from oligopolistic capitalism to super-competitive capitalism.” That although the pay has risen, so have investor returns and even if shareholders had a full say, they would not reduce it. This is his hypothesis, that the reason for the high pay of CEO’s is due to the change in the structure of the economy. Thus, his prediction and use of deductive thinking shows that CEO’s pay is likely to continue to rise substantially over the years.
“The CEO of a big corporation 40 years ago was mostly a bureaucrat in charge of a large, high-volume production system whose rules were standardized and whose competitors were docile. It was the era of stable oligopolies, big unions, predictable markets and lacklustre share performance. The CEO of a modern company is in a different situation. Oligopolies are mostly gone and entry barriers are low. Rivals are impinging all the time -- threatening to lure away consumers all too willing to be lured away, and threatening to hijack investors eager to jump ship at the slightest hint of an upturn in a rival's share price.”
Reich shows us that the job description of a CEO has changed over the past 40 years, an increase in competition in markets have increased the need of a CEO, “who has to be sufficiently clever, ruthless and driven to find and pull the levers that will deliver competitive advantage”. “There are no standard textbook moves, no well-established strategies to draw upon. If there were, rivals would already be using them. The pool of proven talent is small because so few executives have been tested and succeeded.” He shows us, with good reason, that in the ever changing market of today, that executives do deserve their compensation and that executive compensation should not be regulated.
Regulation of Executive Compensation
In the beginning of 2001, but reinforced after September 11, the US Federal Reserve had pursued a policy of low interest rates. For years it was easy to borrow money, and for Americans the dream of owning your own home became a reality. The result is that the demand for houses increased faster than supply, housing prices exploded (Krüger, A., 2008).
“Real estate financiers and regional banks lent billions of dollars to borrowers with questionable credit ratings. These subprime loans - were more expensive than conventional loans generally. Therefore debtors, who had no securities, get credits. After years of unbridled construction boom, on the one hand the supply had overtaken the demand and home prices went back down. On the other hand, the rising interest rates, became for many homeowners a problem. They could not pay their mortgages. Because they can’t pay the loans, many foreclosures of homes take place.” (Krüger, A., 2008).
“The global financial crisis manifested systematic weaknesses in the variable remuneration of executives, directors and employees in the capital market related business areas of international banks. There not being regulation of the variable remuneration in the banking sector facilitated the executives’ to focus on cash out compensation based on the firms' short-term results and accuses that the executives let themselves control by their incentives. It argues that executive pay arrangements might have encouraged excessive risk-taking. This is true, because the executives get large amounts of money from selling shares of their companies” (Bebchuk, L. A., Cohen, A., & Spamann, H., 2010). Therefore, more shares were circulating and thus destabilized the share price. Examples include “Bear Stearns” and “Lehman” who collapsed because of that reason (Bebchuk, L. A., Cohen, A., & Spamann, H., 2010).
However, compensation is not the basis of the financial crisis, and therefore the assumed fact is incorrect. The incentive of managers cannot be blamed for the credit crisis or for the performance of banks Not only the wealth of the companies wiped out but also the wealth of the executives (Bebchuk, L. A., Cohen, A., & Spamann, H., 2010). The problem is that companies are trying to increase, due higher short-term compensation, the commitment of the executives. However, they should create the executive payoffs to long-term results more effectively and eliminate or curtail executives' ability to benefit from short-term results (Bebchuk, L. A., Cohen, A., & Spamann, H., 2010).
It can be seen, that the economists use the scientific method, Gravetter states “The scientific method is a method of acquiring knowledge that uses observations to develop a hypothesis. There are two different empirical ways to determine the prediction which are additional or systematic observation. The new observation results in a new hypothesis, and the cycle continues” (Gravetter, F. J., & Forzano, L. B., 2009). The article also encompasses the faith method, as the data collected for the research paper is assumed to be true by the writers. The economists observed that the financial crises is created by executives of the company. The hypothesis is, that the executives take high risks, to gain the short-term compensations. In that process they disregard the financial situation of the company, and the resulting prediction is that this situation will lead to renewed crisis. However, on closer observation economists find out that the hypothesis is incorrect and that governments have to regulate the compensations, and this cycle continues.

Legal improvements and the current process

Soon after the first symptoms of the financial crisis became apparent, calls for more regulation on executive compensation arose. The public opinion, being more or less balanced before the crash, turned towards blaming the financial companies and especially wall street for being responsible for the financial and economic crisis. In the face of CEOs receiving millions in salaries and bonuses, while numerous workers lose their jobs. Therefore, the share value of the companies massively decreased, and did not seem fair or desirable anymore to not have any regulation on CEOs’ compensation. All around the world, politicians, the media and other representatives of the public opinion raised their concern and anger about that cruel inequality which was going on.

Bonus and compensation packages for executives came massively under pressure from shareholders and legal authorities like the U.S. Securities and Exchange Commission, the U.S. Government and the European Commission. Shareholders and investors started to rejected compensation packages at several companies such as Royal Dutch Shell in 2009 (The New York Times, 2009), Citigroup in 2012 and at Oracle in 2013 (The Guardian, 2012, 2013).

In 2009, German Chancellor Angela Merkel proposed curbs on executive pay to fill a liquidity fund and asked for more transparent executive compensation that sets incentives at more long-term achievements than short-term (The New York Times, 2009). Three years after that, the Spanish government introduced pay-cuts for executives in state-owned and partly state-owned firms of up to 35 percent for about 4,000 companies. Spain also reduced executive salaries at nationalised banks from Euro 600,000 to Euro 300,000 (The Guardian, 2012).
Finally in March 2014, the European Commission adopted new regulatory standards which included the identification of so called material risk takers. According to the EC, a material risk taker is “staff whose professional activities have a material impact on an institution's risk profile” (EC, 2014), and the variable component of material risk takers’ compensation must not exceed 100 percent of the fixed renumeration. Under special circumstances, shareholders can allow a maximum variable component of 200 percent (EC, 2014).
At this stage of development, one can logically relate the concepts from Frederick J. Gravetter to the governments decision. The US Government and the European Commission were massively relying on so called economic experts’ advice when they made regulations for the financial markets and executive compensation, what Gravetter introduces as the “Method of Authority”. Those experts based their advice on the theory that the higher the executives’ salaries were, the more they would be motivated to increase the companies’ performance and the shareholders’ value. After the breakdown of Lehman and the outbreak of the financial crisis, governments changed their method of information inquiry to the “Rational Method” (Gravetter, 2010), which proposes simple reasoning based on rationalism. During the years of the crisis, regulators observed that high executive pay led to massive management failures and bankruptcy of big wall street companies or at least did not prevent the companies from failing. Then they recognised that this high paying culture was still continuing, which brought them to the conclusion that the rules for executive compensation had to be much stricter. That change in information inquiry ultimately led to the regulations imposed from 2010 to 2014.

To see whether these efforts made by the governments helped to create a more sustainable executive compensation, one can take a look at the current development of executive salaries on both sides of the atlantic. In the United States, the median income of CEOs of S&P 500 companies was US-Dollar 10.1 million, which represents a massive increase of 43 percent from 2009. Over the same time period, the non-farm workers hourly wage rose only by 23.6 percent. This data does not prove that the development of salaries went in an unsustainable direction that may harm the company in the future, but it leaves room for concern and it clearly shows that the inequality in wages was definitely not improved.

In Europe, the compensation of executives has been partly adjusted in terms of long-term incentives. According to a 2014 report from Towers Watson about the French CAC 40, the German DAX, the UK FTSE 100, the Dutch AEX and the Spanish IBEX 35, the base pay and the short-term incentives remained mostly stable. The long-term incentives levels remained also stable, but were adjusted by introducing an increased stretch in performance conditions (CAC 40), increased caps on overall variable compensation (DAX), declining of share matching plans and increased prevalence of extended holding periods (FTSE 100), more implementation of qualitative performance data (AEX) and more share based plan (IBEX 35)( Towers Watson, 2014).

Conclusion

We can conclude that executive compensation is a very controversial topic, one that evokes much discussion. Some economists believe that executives deserve their compensation due to the market structure increasing in complexity, while others argue that due to the shear amount of compensation that some executives receive, it should be regulated. We can observe that an increasing number of governments have in fact regulated executive compensation. For example in the European Commission adopted new standards to increase transparency over bankers pay and risk profiles.

References

Babbie , E. (2007). The Basics of Social Research (4 ed.). Belmont: Cengage Learning: Wadsworth.

Bebchuk, L. A., Cohen, A., & Spamann, H. (2010). Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008, The. Yale J. on Reg., 27, 257-267.

CEO’s Deserve Their Pay, Robert B. Reich. Retrieved on January 15, 2015 from http://www.wsj.com/articles/SB118972669806427090

Citigroup shareholders reject CEO Vikram Pandit's pay package, The Guardian. Retrieved on January 15, 2015 from http://www.theguardian.com/business/2012/apr/17/citigroup-shareholders-reject-ceo-pay

Germany: Executive Pay May Be Curbed, The New York Times. Retrieved on January 15, 2015 fromhttp://www.nytimes.com/2009/03/06/business/worldbusiness/06fobriefs-EXECUTIVEPAY_BRF.html

Gravetter, F. J., & Forzano, L. B. (2009). Research Methods for the Behavioral Sciences (3 ed.). Belmont: Cengage Learning: Wadsworth.

Krüger, A., 2008, Tagesschau. Retrieved from http://www.tagesschau.de/wirtschaft/immobilienkrise16.html
Oracle executive pay deal again rejected by shareholders, The Guardian. Retrieved on January 15, 2015 from http://www.theguardian.com/business/2013/nov/01/oracle-executive-pay-deal-rejected-shareholders-larry-ellison

Press Release, European Commission. Retrieved on January 15, 2015 from http://europa.eu/rapid/press-release_IP-14-210_en.htm?locale=en

Shareholders Reject Pay Package for Shell Executives, New York Times. Retrieved on January 14, 2015 from http://www.nytimes.com/2009/05/20/business/global/20pay.html

Spain to limit executive pay at state-owned companies, The Guardian. Retrieved on January 15, 2015 from http://www.theguardian.com/world/2012/feb/17/spain-limit-executive-pay

2014 CEO pay in the Eurotop 100, Towers Watson. Retrieved on January 15, 2015 from http://www.towerswatson.com/en-SE/Insights/IC-Types/Survey-Research-Results/2014/07/2014-CEO-pay-in-the-Eurotop-100-insights-similarities-and-differences-across-Europe