The 2007-2009 Financial Crisis and Executive Compensation: Analysis and a Proposal for a Novel Structure

Abstract

During the 2007-2009 crises financial institutions have come under increasing pressure from regulators, politicians and shareholders to change their compensation practices in order to remove the incentive for short term excessive risk taking. In this paper we analyze first how the common executive compensation, which is composed of equity-based compensation (stocks and executive stock options) and a fixed cash compensation, leads to a concave relationship between assets risk and compensation value and creates an incentive for the executive to choose corner solutions that either lead to an excessive risk taking or to a freeze out of the lending activity to the public. This paper’s main contribution is a novel component, for executive compensation, that is paid only if the value of the firm assets is located in some predetermined range. This new form of compensation motivates the executive to take an intermediate (internal solution) level of assets risk because of the convex relationship between assets risk and compensation value.