The topic of corporate governance in general, and top management compensation in particular, has received enormous attention in recent years. Alignment of the incentives of top management with the interests of shareholders has been characterized as an important mechanism of corporate governance. In fact, there is a large theoretical and empirical literature on the role of incentive contracts in ameliorating agency problems. However, there is less research on the design of managerial compensation structure taking into account its interaction with the other mechanisms of corporate governance.
In this paper, we examine the top management compensation in banking firms. In particular, we study theoretically and empirically the optimal design of compensation, taking into account the unique claim structure in banks, and consequently, the incentives of its claimholders to monitor management. Banks differ from firms in non-financial unregulated industries (e.g., manufacturing firms) in the structure of their claims. This, in turn, gives rise to monitoring mechanisms, which are very different from those in manufacturing firms. A lion's share of a bank's cash flow claims is in the form of debt held by dispersed depositors. Moreover, the Federal Deposit Insurance Corporation (FDIC) insures a large fraction of this debt. Consequently, unlike the case in manufacturing firms, the primary creditors in a bank are do not have sufficient incentives to monitor the bank.
The deposit insurance is equivalent to a put option given to the depositors by the FDIC (see Merton (1977)). Therefore, the regulator has an incentive to monitor the bank, especially with respect to the risk choices of the bank. The banks may also hold subordinated debt in addition to the deposits. The subordinated debt is often held in a concentrated fashion by insurance companies and other financial institutions. The subordinated debtholders also have incentives to monitor the bank, and like regulators, especially with respect to its risk choices. In this paper, we examine the incentive features to be included in the top management compensation structure in banks in the presence of monitoring by regulators and by subordinated debt holders. Understanding how incentive features in management compensation are affected by these governance mechanisms in banks will provide insights useful in the larger context of firms in general.
The role of regulation as a governance mechanism in financial institutions and its interaction with other mechanisms of corporate governance has not been studied. For example, bank supervision that ensures the bank is compliant with regulatory requirements could play a general monitoring role. Is this monitoring a substitute or complement to other mechanisms of corporate governance? In particular, does regulatory monitoring decrease or increase the need for incentive features in managerial compensation? Understanding the nature of the interaction of regulation and corporate governance will give us insights about the optimal design of regulation and corporate governance for banks.
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Regulation, Subordinated Debt and Incentive Features of CEO Compensation in the Banking Industry
