What Did Bank CEOs Know And When Did They Know It?

"One view of executives at our largest banks in the run-up to the crisis of 2008 is that they were hapless fools. Not aware of how financial innovation had created toxic products and made the system fundamentally unstable, they blithely piled on more debt and inadvertently took on greater risks.

The alternative view is that these people were more knaves than fools. They understood to a large degree what they and their firms were doing, and they kept at it up to the last minute – and in some cases beyond – because of the incentives they faced.

New evidence in favor of the second interpretation has just become available, thanks to the efforts of Sanjai Bhagat and Brian Bolton. These researchers went carefully through the compensation structure of executives at the top 14 US financial institutions during 2000-2008.

The key finding is that CEOs were “30 times more likely to be involved in a sell trade compared to an open market buy trade” of their own bank’s stock and “The dollar value of sales of stock by bank CEOs of their own bank’s stock is about 100 times the dollar value of open market buys” (p.4).

If the CEOs had really believed in what their banks were doing, they would have wanted to hold this stock – or even buy more. Disproportionately more sales than purchases strongly suggests that the CEOs felt their stock was more likely overvalued than undervalued.

The problem runs deeper, as Professors Bhagat and Bolton explain. Given the compensation structure of CEOs – particularly the fact that they can sell stock with very little restriction – they have an incentive to take on excessive levels of risk. When the outcomes are good, as they may be for a while in an up market, the CEO can turn his or her stock into cash. When the outcomes are bad, the CEO doesn’t care so much because he (or she) already has cash – and some form of government bailout or other support may be forthcoming.

Bhagat and Bolton argue that if this incentive problem is important, we should see CEOs make a great deal of money while long-term buy-and-hold shareholders lose money..."

at http://baselinescenario.com/2011/02/10/what-did-bank-ceos-know-and-when-did-they-know-it/