Design and Justify an Optimal Compensation Package to Offer Bank Ceo's
Design and Justify an Optimal Compensation Scheme to Reward Bank CEO’s (2500words)
i) Study the principal-agent theory to explain the key requirements that an optimal pay-contract should possibly meet and ii) Apply this to the financial sector in order to come up with an efficient compensation contract for bank CEO’s.
Introduction
The 2008 collapse of Lehman Brothers precipitated the sub-prime crisis, the collapse of major banks and a global economic crisis that resulted in a worldwide recession and trillions of dollars in losses. Many people believe that the compensation-packages of the CEO’s at major financial institutions were hugely geared towards pursuits of larger profits, ignoring the risks that this entailed, resulted in this economic collapse. We will analyse what the purpose of such compensation schemes are and how the principal-agent problem comes into play. The common critiques and differing views of whether CEO’s payment schemes encourage excessive risk-taking will also be considered while the efficiency of such schemes and how to increase it will be evaluated. Finally we’ll try to come up with a compensation-package that will provide enough incentive for the CEO to increase profits at the same time as minimising excessive risk-taking. Banks are the cornerstone of any economy and as such it’s vitally important that they function efficiently.
The structure of the essay will be as follows: Section 2 will discuss the principal-agent theory. Section 3 will look at the efficient market view theory. Section 4 will review key features of different payment-schemes and evaluate their pros and cons. Section 5 will propose a possible solution for an optimal CEO compensation scheme. Section 6 will conclude.
Section 2:
Principal-Agent Theory
The assumption that underpins the principal-agent theory is that there’s a separation between ownership and control in all major companies, with shareholders being principals and CEO’s being agents. These large
i) Study the principal-agent theory to explain the key requirements that an optimal pay-contract should possibly meet and ii) Apply this to the financial sector in order to come up with an efficient compensation contract for bank CEO’s.
Introduction
The 2008 collapse of Lehman Brothers precipitated the sub-prime crisis, the collapse of major banks and a global economic crisis that resulted in a worldwide recession and trillions of dollars in losses. Many people believe that the compensation-packages of the CEO’s at major financial institutions were hugely geared towards pursuits of larger profits, ignoring the risks that this entailed, resulted in this economic collapse. We will analyse what the purpose of such compensation schemes are and how the principal-agent problem comes into play. The common critiques and differing views of whether CEO’s payment schemes encourage excessive risk-taking will also be considered while the efficiency of such schemes and how to increase it will be evaluated. Finally we’ll try to come up with a compensation-package that will provide enough incentive for the CEO to increase profits at the same time as minimising excessive risk-taking. Banks are the cornerstone of any economy and as such it’s vitally important that they function efficiently.
The structure of the essay will be as follows: Section 2 will discuss the principal-agent theory. Section 3 will look at the efficient market view theory. Section 4 will review key features of different payment-schemes and evaluate their pros and cons. Section 5 will propose a possible solution for an optimal CEO compensation scheme. Section 6 will conclude.
Section 2:
Principal-Agent Theory
The assumption that underpins the principal-agent theory is that there’s a separation between ownership and control in all major companies, with shareholders being principals and CEO’s being agents. These large
Bibliography: ‘Firmly Hooked’ Article - The Economist.com (August 2009) ‘Compensation and Risk Incentives in Banking and Finance’ Article – Kent Cherny (October 2010) ‘Bank Chiefs Pay Rises by 36%’ Article – Megan Murphy - Financial Times Online (June 2011) ‘CEO Compensation’ - Frydman & Jenter (2010) ‘Entrenchment and Severance Pay in Optimal Governance Structures’ - Almazan & Suarez (2003) ‘Crazy Compensation and the Crisis’ – Alan Blinder (2009) ‘Compensation Structure and Systematic Risk’ - K. Murphy (June 2009) ‘Bank CEO Pay’ – Financial Times Online (2010) Further reading included: ‘Is CEO pay really inefficient?’ – A.Edmans (2009) ‘The Credit Crisis: Conjectures about causes and remedies’ – Diamond & Rajan (Feb. 2009) ‘CEO Compensation: A proposal for efficient incentive contracting in Banks’ – Bingxun Seng (2010) ‘Regulator Scrutiny and Bank CEO Incentives’ – E.Webb (2007) -------------------------------------------- [ 5 ]. Blinder, 2009, Crazy Compensation and the Crisis [ 6 ] [ 7 ]. Financial Times, 2010, Ft.com/alphaville