Executive Compensation at Banks Receiving Federal Assistance under the Troubled Asset Relief Program (TARP)

ABSTRACTThe recent recession in the US economy was triggered by a severe financial crisis that threatened a collapse of the American banking system. The banking industry has subsequently faced intense political and regulatory scrutiny, with one of the primary targets being executive compensation. As a result, limits were placed on executive pay at banking institutions bailed out by the federal government under the 2008 Troubled Asset Relief Program (TARP). This paper reviews the contractual issues affecting the compensation of bank executives and analyzes the compensation policies of the largest banks receiving government bailout money under TARP. We report that CEO pay, particularly incentive compensation in the form of bonuses and stockbased compensation, decreased markedly following the bailout. Thus, it appears that compensation was reduced at most TARP recipient banks following the government bailout of the banking industry.INTRODUCTIONThe recent recession in the American economy represents the largest economic downturn since the Great Depression. While many factors contributed to the slump, the financial services industry faced some of the most serious criticism due to the subprime mortgage crisis, the collapse of the housing market, and the stagnation of global credit markets. In order to stem the crisis and restore credit markets, the US Congress approved a $700 billion bailout package in late 2008 to stabilize the financial sector (Herszenhom, 2008). A significant feature of this plan was the Troubled Assets Relief Program (TARP), which was designed to buy troubled assets from financial institutions that had been weakened by the subprime mortgage crisis. Purchasing these assets allowed banks to stabilize their balance sheets and avoid further losses (Congressional Budget Office, 2009). However, taxpayers were outraged when they discovered the levels of compensation received by executives of these struggling financial institutions. In March 2009, for example, executives from insurer AIG received a combined $165 million in compensation after AIG had received a substantial infusion of TARP funding to avoid bankruptcy. This situation triggered heightened public scrutiny of the legitimacy of rewarding financial executives considered to be responsible for policies that led their firms into financial difficulty (Reddy & Bendavid, 2009). This study examines the compensation policies of banks receiving the largest levels of TARP funding in order to gain insight into the effects of the financial crisis and increased public scrutiny on levels of executive pay. We focus on the three-year period around the financial crisis of 2008 in order to evaluate changes in the compensation policies of TARP recipients. While non-banking institutions also ultimately participated in the TARP program (e.g., AIG and certain US automobile companies), we focus only on banks in order to retain industry homogeneity in our sample. Our results indicate that most banks decreased CEO pay throughout the three years of the study, particularly incentive compensation such as bonuses and stock options. However, we find that the decrease in pay was greater following the heightened public scrutiny that followed the disclosure of sizable AIG compensation in early 2009 and the modification of TARP to establish limits on executive pay for recipients of bailout funds.LITERATURE REVIEWAgency Costs and CompensationThe contractual motivations for the elements of executive compensation are commonly traced to Jensen and Meckling's (1976) seminal work on agency theory, which presumes a conflict of interests between the goals of principals and the goals of agents who work on their behalf. Their theory holds that, in order to minimize agency costs, contracts should provide incentives for managers (agents) to subordinate their personal interests in order to serve the interests of their principals. The goal of contracting is to structure the contractual relationship so that an agent will make choices that maximize the principal's welfare. …