Is Curbing Executive Pay Really the Answer?

“This is the problem at hand, and it does need a solution,” said Sam Germaine, an associate at ETF Venture Funds who traveled from Philadelphia to attend the Robert H. Smith School of BusinessThoughtLeadership@Smith series event on Executive Compensation and Public Policy on September 18.

Lemma W. Senbet, the William E. Mayer Chair Professor of Finance, presented what he coined the “dark side” and the “good side” of the issue of executive compensation.

The timing could not have been better. TheWall Street Journal recently reported that a proposal put forth by the Federal Reserve would allow the Fed to reject the compensation policies in all U.S. banks, with special scrutiny of the largest 25. The proposal, according to the Fed, is intended to reign in existing pay practices that might distort incentives for everyone from chief executives to loan officers. The proposal does not require congressional approval.

But the question is not, according to Senbet, whether executives are paid too much. The question is how to structure compensation with sufficient incentives for optimal performance, recognizing that optimal performance, by definition, requires some level of risk.

In other words, Senbet said, “How can executive compensation be structured to reward executives for good while also penalizing them for poor performance? Is the pay-performance sensitivity too low? Do contemporary compensation contracts promote a short-term outlook that encourage executive gaming? And do executive stock options provide perverse incentives?”

Senbet, a world-renowned scholar in financial economics, offered some answers to these questions.

Smith School professors Lemma Senbet (l) and Alan Jacobs (r)

Wayne Kimmel ’97

“I am a very strong opponent of attempts to limit pay,” Senbet explained, as he criticized public reactions and regulatory responses to the two landmark events that have recently shaped society and the global business environment: the burst of the information technology boom and ensuing corporate scandals involving Enron, WorldCom and Adelphia, and the burst of the housing bubble and the subprime debacle.

“While supporting the need to reform corporate governance mechanisms influencing compensation setting, we should not support direct or indirect efforts to legislate or regulate compensation levels and structures,” said Senbet.

Instead, he proposed reforms in corporate governance that ensure compensation committees are truly independent and have at least one financially literate member, and enhancements in compensation disclosure that includes all elements of executive compensation and exposes executives’ trading activities in the open markets.

In addition, he proposed that FDIC rates be utilized to manage risk choices by bank managers, and executive compensation can then be left to the bank owners. Senbet recommends that bank executive compensation include the appropriate balance of three components: a fixed salary, a fraction of the equity of the bank, and a bonus.

“It’s a big world out there,” noted Dennis Horn, a partner at Holland and Knight who attended the event. He asked if the U.S. could model its compensation structure against any other countries or systems that might be doing it right. Senbet suggested that any model should be based on components of other countries’ practices, not a mirror of any existing system. He also cautioned again against the U.S. imposing executive pay limits when other countries and markets do not. “If they don’t but we do, we lose,” he said.

Senbet’s financial policy leadership role extends to advising government and businesses. His outreach on this and other financial policy issues will expand in the newCenter for Financial Policy at the Robert H. Smith School of Business. The Center launches on November 2, 2009, with a policy roundtable on executive compensation.

Not coincidentally, the Center’s keynote speaker at that roundtable is none other than Ken Feinberg, Obama’s pay czar—who, separate and apart from the Fed proposal, is currently evaluating the proposed compensation packages for seven companies that received "exceptional" assistance from the taxpayer-funded $700 billion bailout, including American International Group Inc., Bank of America Corp., Citigroup Inc., General Motors, GMAC, Chrysler and Chrysler Financial.

For more information: www.rhsmith.umd.edu/cfp.

The ThoughtLeadership@Smith series presents Smith’s world-class faculty discussing their latest research on topics of broad interest and importance, and allows alumni, students and the business community to ask questions and network. The series will continue this fall with two sessions in Washington, D.C. and three in Baltimore.