Efforts to control bank risk-taking by regulating executive pay presume that non-executive pay is set internally. Bank executives, they suppose, can determine how non-executives are paid once their own pay is regulated, bringing non-executives into line by using incentives to manage risk-taking.
What those efforts overlook is the effect on non-executive pay of the competition to hire new talent. As this Article describes, prior to the 2007 financial crisis, the level of non-executive incentives was determined largely by the market demand for talent. Hiring typically is based on short-term results, since it is difficult for employers to fully assess a current or prospective hire’s long-term performance. Non-executives, therefore, have an interest in incurring significant risks upfront — bootstrapping short-term performance and leaving for a new job before losses materialize. The rewards are greater compensation from new or existing employers that compete for staff who performed well in the short-term. Non-executive pay, therefore, is a function more of market demand — increasingly set by non-banks — than of what a bank’s executives believe to be optimal in influencing performance.
New regulation must address the tension between competition and compensation. Regulators should take account of the effect of competition on market-wide levels of pay, including by non-banks who compete for talent. The ability of non-executives to jump from a bank employer to another financial firm should also be limited. In addition, new regulation should restrict an employer’s ability to offset losses that new employees incur based on compensation paid by a prior employer that is tied to long-term performance.