Archive for November 5, 2008

Rajan: “We need to make people a little more worried about the future”

Andrew Ross Sorkin’s article in NYT Deal Book highlights Raghuram Rajan’s suggestions for improving executive compensation. Rajan, finance professor at the University of Chicago and former chief economist at the IMF (whom I met when I was at Brookings and Rajan was promoting his book with Zingales), has some interesting ideas on how incentive contracts could be drawn up to make executives “a little more worried about the future,” and how the government can encourage firms to take these steps.

First, how to encourage long-termism through executive pay: Rajan suggests that bonuses should be paid out over a longer period and subject to “clawbacks” so that they can be revoked if the results don’t stand up. These are moves that shareholder activists have been pushing for a while. More striking to me is Rajan’s suggestion that pay should be tied more tightly to accounting results, and less tightly to stock price. It’s a widespread view by now that stock options, which have large upside but little downside risk, encourage unproductive gambling with corporate assets; it’s a less widely-held view that stock grants also induce the wrong kind of behavior. I think the argument is that stock prices depend too much on phenomena that are beyond the executive’s control and thus provide a poor measure of how well the executive is performing.

It’s tempting to think that we can encourage executives to focus on things we care about (controlling costs, generating revenue, creating long-term sustainability etc) by rewarding accounting results, but I wonder — how do you set up a contract based on accounting results that encourages something hard to measure, like judicious investment in R&D? The alluring thing about stock compensation is that, in theory, the executive gets paid well if the analysts (and the market more broadly) think that the company’s investments will produce a nice stream of profits in the future. If the market is efficient and understands the firm’s actions and accurately prices future cash flows, this can create exactly the right incentives to undertake productive investments. The market does not of course do this perfectly, which makes stock grants imperfect incentive tools, but the question remains whether we can do better with bonus packages derived from accounting results.

Leaving aside these concerns, how do we get companies to adopt enlightened compensation packages? Rajan is skeptical that boards will do so of their own accord (again suspicious of the market), so he wants the government to reward firms that institute reforms. (In short, he wants the government to create incentives for firms to implement good incentives.) In the case of the financial sector, banks that choose to adopt reforms in executive pay would face lower capital adequacy requirements, since their governance makes them less risky than similarly leveraged banks that have not instituted pay reforms. (Rajan’s argument appears to be based on looking at banks in the context of the bailout, but for other kinds of firms other levers of influence such as tax policy could of course be used.)

Writing this up as policy would be a hard thing to do, because it requires agreeing on what good executive compensation looks like. (See above.) I would guess it’s unlikely that a comprehensive government solution like this will emerge. But I remain confident enough in the equity markets to believe that firms will innovate on executive compensation as a way of attracting investment. I would look for reforms coming both from shareholder activists and from boards themselves.


November 5, 2008 at 10:34 pm Leave a comment


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