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The Stock Compensation Conundrum

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The idea that bank CEO's would get richer—as a consequence of post-stress test dividends—began to spread days before the banks even announced their dividend disbursements last Friday.

Erich Dash, writing in The New York Times DealBook on Wednesday, captured the nub of the debate.

Here's Dash's summary of the background information, which explains the logic behind banks making the shift from a cash compensation model to an equity based compensation model:

"To some extent, the expected windfall comes because banks have been paying executives a greater portion of their compensation in stock instead of salaries or bonuses. Regulators hoped that if banks handed out more shares and other forms of deferred pay, executives would avoid the type of excessive risk-taking that contributed to the financial crisis in 2008 and 2009."

Similarly, Dash's analysis cuts right to the chase on the downsides of banks making the shift in pay models. Specifically, he points to two principal issues. First, the windfall profits of management—which, one suspects, may be a political liability to the banks in our current political and economic climate. Second, to a total absence of transparency in how the compensation will be reported to investors and the world at large.

"Several other banks have said they plan to pay a similar percentage of earnings to shareholders. So chief executives stand to reap especially large gains because they are traditionally among the biggest holders of company stock. Corporate governance experts do not typically fret about such payouts since they help align the interests of management with those of investors more equally than other compensation practices. However, the dividends collected by chief executives will not be broken out in the compensation tables found in corporate filings. Investors must crunch the numbers themselves."

But Dash's phrasing is careful: He writes that dividend payments 'help align'—rather than just plain 'align'—management interests with investors, which is exactly right.

Paying out executive remuneration to management in the form of stock compensation is helpful —but it isn't a panacea. While it may be a good start in aligning interests, there are plenty of complications.

For example, the stock compensation model can still present an asymmetric risk/reward profile to bank executives. When management receives stock grants, they're not paying for those shares with the same opportunity cost that other investors do when purchasing them with cash. Structurally, that may encourage risk taking in ways that wouldn't benefit shareholders—especially over longer time horizons.

And stock compensation models also do little to help align management interests with another key investor constituency: The bondholders—who bear the risks over the long haul if management's riskiest bets fail to pan out.

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