Although exorbitant executive bonuses are not solely to blame for the far-reaching effects of the 2008 global financial crisis, there is sufficient evidence that opulent bonuses indeed contributed to and even exacerbated the crisis.
First, changes to the tax code during the 1980s to 1990s, in an attempt to curtail excessive bonuses, actually contributed to exponential growth in CEO pay witnessed today. Public concern about the large number of mergers in the mid 1980s instigated changes to the tax code. The main concern stemmed from potential conflicts of interest between regulators and investors versus the managers engaging their firms in the mergers. The regulators and investors wanted to ensure that managers were engaging in mergers because it was a financially sound move that would enrich and optimize the long-term position of the company. There was much angst, however, that the burgeoning number of mergers was a reflection of selfish, short-term management incentives, namely inflated severance packages and golden parachute payments upon leaving the company. A 1986 amendment to the tax code created a penalty tax on golden parachute payments that exceeded three times an executive’s base pay. This change had an opposite effect on management practices and compensation structures than that intended. As a consequence of this amendment, companies began routinely paying this penalty tax for executives and thus the triple base pay became the standard for, rather than the exception to, many golden parachutes were previously negligible in comparison with the new standard perk. In 1993, another amendment to the tax code limited tax deductibility for executive pay at $1 million. The exception was “performance-based” compensation, and stock options fell under this category. Subsequently, this tax code amendment catalyzed the growth in stock options and incentivized executives to engage in high-risk transactions that boosted their companies’ stock prices.
A second factor responsible for burgeoning top executive pay within the financial industry is the compensation structure. Base pay is typically negligible in comparison with bonus pay. This structure results in moral hazard: managers have a very compelling incentive to engage in high risk, high return ventures because this translates to high bonuses for the managers and exponential growth in investors’ profits. In contrast, the managers have a strong disincentive to engage in sound, low risk, low return ventures because such ventures invariably command less than optimal market rates, low bonuses, and below potential returns for investors. Similarly, in a venture fraught with high risk, the worst outcome for the manager is zero bonuses and possible termination. The stakes involved in risky ventures are therefore much higher for the investors. Thus, the interplay between asymmetric information and moral hazard has been integral in boosting top executive bonuses.
Lastly, potential conflicts of interest have arisen from the practices used to select members for the Board of Directors. Under the current structure, the Board of Directors consists of three main groups: executives of the firm, prominent executives from non-competing firms, and academic notables. The incentives of the first two groups are disproportionally weighted toward increasing executive compensation rather than protecting shareholder interests. The academicians are usually a minority and have a disincentive to vote against the majority by the high potential profits involved for compliance with the popular vote. Investor protests and executive perks support the claim that directors are excessively compliant. One perk in particular, the “golden coffin,” extends severance type benefits to the heirs of CEOs and other top executives.
In the post-crisis environment, regulators must take steps to ensure thorough monitoring…