Rebalance bankers’ bonuses: Use write-down bonds to satisfy both supervisors and shareholders

Abstract

Governance at banks, especially major banks, requires further reform, especially with respect to incentives. Supervisors are concerned that incentives may make executives prone to take “excessive” risks. Shareholders are concerned that banks rarely earn their cost of capital. What’s needed is a bonus system that explicitly includes the objectives of both supervisors and shareholders, as well as one that balances risk and reward for both the executive and the bank. To this end we propose that senior managers and material risk takers must defer a significant portion of any bonus and that this deferred portion be paid in the form of write-down bonds, with write-downs to occur if the bank incurs fines or makes a loss. The executive can only realize cash from the deferred portion of the bonus award at the end of the deferral period, when it is much more certain that the originally stated profits will not have been reversed by fines, restitutions or defaults. During the deferral period, accrued bonus will effectively constitute a first-loss reserve for the bank. It will bear loss before common equity, whilst the bank is a going concern. The possibility of such loss should concentrate the minds of management on preventing it. This should address the concerns of supervisors and the public at large. For shareholders, such a bonus system ensures that, if the bank makes a profit, they will be paid first, not management. Before executives are awarded any bonus, shareholders will first be compensated for the cost of the equity that they provide to the bank. However, that cost will be lower, the greater is the cumulative first-loss reserve available to absorb loss. In sum, under the revised bonus system executives will both be responsible and rewarded for the risks they decide the bank should take. They will bear first loss, but share in the economic profit that the bank does make.