Bridge over ocean
1 May 2014 CFA Institute Journal Review

Aligning Incentives at Systemically Important Financial Institutions: A Proposal by the Squam Lake Group (Digest Summary)

  1. Jennie I. Sanders, CFA

Measures that would encourage financial firms to be more risk averse would better align the incentives of management with those of bondholders. Firms are currently motivated by the prospect of bailouts and equity-linked executive compensation, which does not benefit bondholders.

What’s Inside?

By withholding a fixed amount of compensation and issuing contingent convertible securities, both of which are tied to a bank’s regulatory capital ratio, financial firms can improve the alignment of management’s and bondholders’ incentives. The withheld compensation is forfeited when the ratio falls below a high trigger point, and the contingent debt converts to equity when the ratio falls below a low trigger point.

How Is This Article Useful to Practitioners?

Aligning management’s incentives with those of bondholdersis of particular interest to long-term investors and taxpayers—those who pay when firms deemed too big to fail are bailed out. The authors note that the incentive to take on riskier projects may be muted by managers’ career concerns, regulations, and bond covenants. Senior managers, however, tend to have large equity claims that align their interests with those of shareholders, which can skew their decision-making process more toward risk than a bondholder may prefer when evaluating projects.

The prospect of government bailouts creates a conflict of interest between taxpayers and shareholders that is similar to the conflict between bondholders and management/shareholders. Financial firms are incentivized to finance risky investments with excessive leverage instead of recapitalizing by issuing equity, which would dilute existing shareholders.

Expanding on previous research, the authors recommend a scheme that would incentivize management to recapitalize the firm before society suffers from the firm’s bankruptcy or bailout. Recently issued UBS bonus bonds illustrate this scheme, with management forfeiting its deferred compensation when the bank’s regulatory capital ratio falls below 7.5% and its contingent debt converting to equity when the capital ratio falls below 5%.

Abstractor’s Viewpoint

The authors present a compelling and creative solution to the social hazard created by the prospect of government bailouts. Aligning incentives in the manner suggested may go further than regulations to discourage potentially destructive decision making.

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