Design and Justify an Optimal Compensation Scheme to Reward Bank CEO’s (2500words) i) Study the principal-agent theory to explain the key requirements that an optimal pay-contract should possibly meet and ii) Apply this to the financial sector in order to come up with an efficient compensation contract for bank CEO’s.
The 2008 collapse of Lehman Brothers precipitated the sub-prime crisis, the collapse of major banks and a global economic crisis that resulted in a worldwide recession and trillions of dollars in losses. Many people believe that the compensation-packages of the CEO’s at major financial institutions were hugely geared towards pursuits of larger profits, ignoring the risks that this entailed, resulted in this economic collapse. We will analyse what the purpose of such compensation schemes are and how the principal-agent problem comes into play. The common critiques and differing views of whether CEO’s payment schemes encourage excessive risk-taking will also be considered while the efficiency of such schemes and how to increase it will be evaluated. Finally we’ll try to come up with a compensation-package that will provide enough incentive for the CEO to increase profits at the same time as minimising excessive risk-taking. Banks are the cornerstone of any economy and as such it’s vitally important that they function efficiently. The structure of the essay will be as follows: Section 2 will discuss the principal-agent theory. Section 3 will look at the efficient market view theory. Section 4 will review key features of different payment-schemes and evaluate their pros and cons. Section 5 will propose a possible solution for an optimal CEO compensation scheme. Section 6 will conclude.
The assumption that underpins the principal-agent theory is that there’s a separation between ownership and control in all major companies, with shareholders being principals and CEO’s being agents. These large organisations are owned by so many shareholders (principals) that no single shareholder holds a significant enough shareholding to affect the actions of the CEO. Principal-agent issues will arise when the CEO makes decisions that affect the wealth and goals of the shareholders. The shareholders objective is normally considered to be to maximise the value of the firm and their ROI, while the agent’s primary objective is to maximise his own compensation. There are many factors that influence the decisions the agent makes and result in outcomes which conflict with the shareholders goals:- One such factor is the economy itself. CEO’s could be facing economic uncertainty and hence be unable to predict which way the economy would go. This could result in poor decisions which may not come to light in a booming economy, whilst consequently correct decisions may still lead to losses in a recession. One such factor is the economy itself. CEO’s could be facing economic uncertainty and hence be unable to predict which way the economy would go. This could result in poor decisions which may not come to light in a booming economy but eventually end up with losses for the bank, whilst conversely correct decisions may still lead to losses in a recession. CEO’s could be aiming to put the least effort into the job while delivering their shareholders just enough so that they wouldn’t get fired. This is where the case of asymmetric information comes in play. This means that the shareholders would essentially have less information than the agent (CEO) and wouldn’t be in a position to monitor the effort that they were putting in. With a CEO normally having got their jobs due to the fact that they are highly-qualified and an industry-expert, even if the principals were able to monitor their actions they may not be able to deduce whether or not the decisions that the agent is taking are the right ones. The monitoring of agents is something that the Board-of-Directors, to a certain extent,...
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