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New evidence on CEO pay rebuts Darling

Allister Heath
LET us, for once, put the emotion and anger to one side. What real, rigorous, academic evidence is there supporting the view that bonuses caused or were a significant contributor to the financial crisis (rather than other factors being to blame, such as ultra-loose monetary policy or flawed risk models)? The answer: very little. In fact, the best research on the subject &ndash; and one which has gone unreported in Britain &ndash; suggests that bonuses paid to bank CEOs had absolutely no impact on the crisis whatsoever.<br /><br />Yes, you&rsquo;ve heard me right. The paper, being circulated among academics, is not comprehensive &ndash; it analyses whether the pay structure of the likes of Sir Fred Goodwin of RBS, Andy Hornby of HBOS or Dick Fuld of Lehman Brothers was to blame, rather than bonuses of traders.&nbsp; But it is the best we have &ndash; and suggests Alistair Darling&rsquo;s speech yesterday, while good politics, was poor economics. <br /><br />The authors &ndash; Rene Stulz of the Swiss Federal Institute of Technology Lausanne and Ohio State University, and R&uuml;diger Fahlenbrach of Ohio and the National Bureau of Economic Research &ndash; are dispassionate observers with no axe to grind. In Bank CEO Incentives and the Credit Crisis, they performed an econometric analysis of 98 US banks with assets of $12.3 trillion, testing a huge amount of data to find what variables might have helped or hindered firm performance. <br /><br />Their aim was to analyse several claims, including that CEOs were too focused on the short run; that stock options incentivised bosses to take too many risks at the expense of shareholders; and that CEOs thought they could increase the value of their shares by investing in volatile assets by leveraging up their firms.<br /><br />Their findings are devastating. It is worth quoting the main ones at length: &ldquo;We have uncovered no evidence&hellip;that better alignment of incentives between CEOs and shareholders would have led to better bank performance or that stock options are to blame... CEOs who took exposures that performed poorly during the crisis did so because they thought that doing so was good for shareholders as well as for themselves. Our evidence provides no support for the hypothesis that stock options led CEOs to take on more exposures that performed poorly during the crisis&hellip; CEOs did not expect these exposures to work out poorly&rdquo;. In a nutshell: bank CEOs misjudged the state of the world and made stupid mistakes. They would have failed whether or not the bonus and stock option system was in place.<br /><br />Instead, the authors discovered that banks whose stock price did well&nbsp; in 2006 at the height of the bubble performed especially badly during the collapse. Clearly, the markets were cheering on the silliest risk-taking firms. Banks with a higher book-to-market value ratio &ndash; accounting value of assets, divided by market cap &ndash; suffered worse during the crisis, presumably because banks with less franchise value took more risks that worked out poorly. <br /><br />If CEOs had taken risks they knew were excessive, they would have sold shares ahead of the crisis. This did not happen. In fact, CEOs increased their stakes and options in their banks in the run-up to disaster and were subsequently hammered. On average, the research reveals that bank CEOs personally lost $30m each in 2008.<br /><br />At the very least, plenty of food for thought for those who care to listen.<br />allister.heath@cityam.com<br />