Corporate Governance and Executive Compensation in Financial Firms: The Case for Convertible Equity-based Pay

Abstract

Unlike the failure of a nonfinancial firm, the failure of a systemically important financial firm will reduce the value of a diversified shareholder portfolio because of economy-wide reductions in expected returns and a consequent increase in systematic risk.  Thus, diversified shareholders of a financial firm generally internalize systemic risk, whereas managerial shareholders and blockholders do not.  This means that the governance model drawn from nonfinancial firms will not fit financial firms.  Regulations that limit risk-taking by financial firms can thus provide a benefit, rather than necessarily impose a cost, for the typical diversified public shareholder.  Managerial shareholding also gives rise to a particular problem of the CEO who, despite the increasing precariousness of the firm’s position, may be reluctant to pursue equity infusions or to sell the firm because of the resulting dilution of his ownership stake.  This might be called the “Fuld problem.”  To mitigate excessive risk-taking both in ordinary operations and as the firm approaches financial distress, this paper proposes a new compensation mechanism for senior managers: convertible equity-based pay.  Upon certain external triggers––for example, a regulatory downgrade into a high-risk category, deterioration in a key financial ratio, or a significant stock price drop––such stock-based compensation should convert into subordinated debt, at a valuation discount.  This will give managers an incentive to curb excessive risk-taking and, in particular, to steer the firm away from financial distress.