A solution to limit risks via incentives

Yale Law School has roundtable discussions on current topics. On Feb 13, 2009 it had a discussion on future of financial regulation. It was divided across 4 sessions with top economists presenting papers and debates.

Session 1:  Crisis Origins and Historical Comparisons
Session 2:  Causes of the Crisis: Conflicts, Compensation and Reputation
Session 3:  Reforming Financial Institution Regulation
Session 4:  Reforming Subprime Mortgages

I came across this paperfrom Sanjali Bhagat and Roberta Romano. They propose a way to limit risks via the incentive route. In this crisis, it has been seen how incentives lead to gains for the employee and adds risks to the organisation.

We suggest that executive incentive compensation plans should consist only of  restricted stock and restricted stock options , restricted in the sense that the shares cannot be sold or the option cannot be exercised for a period of at least two to four years after the executive’s resignation or last day in office. This will provide superior incentives for executives to manage corporations in investors’ longer-term interest, and diminish their incentives to make public statements, manage earnings, or accept undue levels of risk, for the sake of short-term price appreciation.

 This looks like a pretty simple idea. Why wasn’t it implemented?

The authors point that instead of applying restrictions on incentives (like Obama did) it is better to design incentives in a manner that limits risks to the organisation. They point that executive compensation has always been a source of public outcry but regulations to limit them have not been effective. People always know a way out to redesign their compensation so that they do not violate the law but also get more compensation!

Good overview on compensation issues in US financial sector.

Infact, all papers presented in the round-table look quite good.

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