Linkage between Executive Compensation and Financial Sector Meltdown

The report, which is authored by Steve Davis and Mark Lukomnik shows how executives can cause unintended harm and risk on a company by asking the question, “In our quest for pay-for-performance, have we—boards, executives, and shareowners alike—created pressure points that influence risk-taking behaviors in unintended ways?”  To answer this question the authors use the analogy of driving a car in different environment’s to help readers better understand the amount the risk that should be taken and provides steps companies can take to prevent financial crisis.

Risk is not always bad; actually taking risk is what causes many companies to succeed.  However, the risk that companies take should be known and inherent.  Therefore, it is very important for companies to understand its known and inherent risks and be prepared for its unknown risks.  Looking at these risks and determining the role management plays may prevent another financial sector meltdown and prevent companies from taking high-leveraged risk without fully knowing the implications. 

There are three areas companies can improve upon to help its board and executive management. These areas are: distinguish between strategic risk-setting and tactical execution, ensure the board can understand the strategy, and provide them with a good source of information.  By following theses three steps the board will be able to provide management with the tools they need to make good strategic decisions based on the companies risk tolerance and maybe prevent another financial crisis like the one many companies are facing now because of the subprime fallout. 

It is also important to realize that just because you perform these three steps that management may not complete tasks in the time frame required to meet the board’s approval.  Therefore, it is necessary to have incentives for management.  However, monetary incentives can lead to management moving too fast to meet a certain goal and miss important inherent details distinguished by the board.  This is a simple issue though.  To make sure that management is not only concerned with getting their bonuses and increased compensation packages companies can implement a claw-back policy.  This policy states that a company can reclaim compensation awarded as a result of performance, which later need to be restated.

To prevent further financial meltdowns, it is important for the board and executive management to be on one accord.  This allows the company to take necessary risks and to have safeguards in place for when bad decisions are made. 

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Original Article Source: “Towards an Accountable Capitalism,” Global Corporate Governance Forum, 2006