Aligning Incentives at Systemically Important Financial Institutions: A Proposal by the Squam Lake Group

To address the moral hazard problem that can motivate bank executives to take excessive risks and to fail to raise capital when needed, a group of 13 distinguished financial economists recommends that systemically important financial institutions be required to issue contingent convertible debt (CoCos) and to hold back a substantial share—as much as 20%—of the compensation of employees who can have a meaningful impact on the survival of the firm. This holdback should be forfeited if the firm's capital ratio falls below a specified threshold. The deferral period should be long enough—the authors suggest five years—to allow much of the uncertainty about managers' activities to be resolved before the bonds mature. Except for forfeiture, the payoff on the bonds should not depend on the firm's performance, nor should managers be permitted to hedge the risk of forfeiture. The threshold for forfeiture should be crossed well before a firm violates its regulatory capital requirements and well before its contingent convertible securities convert into equity. The Swiss Bank UBS has paid bonuses to its top 6,500 executives that have been structured in exactly this way. Management forfeits its deferred compensation if the bank's regulatory capital ratio falls below 7.5%, and its contingent convertible debt is set up to convert into equity if the bank's capital ratio falls below 5%.