The Structure of Banker's Pay

While executive compensation is often blamed for the excessive risk taking by banks, little is known about the operating performance incentives used in the finance industry both prior to and subsequent to the recent crisis. We provide a comprehensive analysis of incentive design -- the link of compensation to operating performance -- in financial firms and compare incentive structures in financial firms to those in non-financial firms. Top executives in financial firms are paid less than their counterparts in non-financial firms of similar size and performance. Banks (and insurance firms) link a larger fraction of top executive pay to short-term accounting metrics like ROE and EPS and a smaller fraction to (long-term) stock price. Performance targets for bankers are not related to the risk of the bank, and ROE targets are not appropriately adjusted for leverage. Consequently, the design of executive compensation in banking may encourage both high leverage and risk-taking, and our evidence provides a potential explanation for the strong positive correlation that we document between the extent of short-term pay for bank CEOs and the risk of the bank before the financial crisis.