Did Bank CEO Compensation Cause the Financial Crisis?

Posted by Mark A. Calabria

Earlier this summer, the House of Representatives approved legislation intended to, as Rep. Frank, put it, “rein in compensation practices that encourage excessive risk-taking at the expense of companies, shareholders, employees, and ultimately the American taxpayer.”

While there are real and legitimate concerns over CEOs using bailout funds to reward themselves and give their employees bonuses, Washington has operated on the premise that excessive risk-taking by bank CEOs, due to mis-aligned incentives, caused, or at least contributed to, the financial crisis.  But does this assertion stand up to close examination, or are we just seeing Congress trying to re-direct the public anger over bailouts away from itself and toward corporations?

As it turns out, a recent research paper by Professors Fahlenbrach (Ecole Polytechnique Federale de Lausanne) and Rene M. Stulz (Ohio State) conclude that “There is no evidence that banks with CEOs whose incentives were better aligned with the interests of their shareholders performed better during the crisis and some evidence that these banks actually performed worse…”

Professors Fahlenbrach and Stulz also find that “banks where CEOs had better incentives in terms of the dollar value of their stake in their bank performed significantly worse than banks where CEOs had poorer incentives.  Stock options had no adverse impact on bank performance during the crisis.”  While clearly many of the bank CEOs made bad bets that cost themselves and their shareholders, the data suggests that CEOs took these bets because they believed they would be profitable for the shareholders.

Of course what might be ex ante profitable for CEOs and bank shareholders might come at the expense of taxpayers.  The solution then is not to further align bank CEOs with the shareholders, since both appear all too happy to gamble at the public expense, but to limit the ability of government to bailout these banks when their bets don’t pay off.

Winters’ Content Standards — Can they Work?

Posted by Andrew J. Coulson

Marcus Winters offers a clever new national standards proposal in the current Education Week: reward states whose students do well on their own standards _and_ whose standards prove challenging to students from other states. Winters suggests administering each state’s standardized tests to random, nationally representative samples of students to determine how challenging they are. The federal government would then give the greatest amount of funding to states whose students perform well on tests that prove challenging to kids around the country.

This system would be gamed. The way to “win” would be to develop highly detailed, easy, obscure standards. Literature would consist of detailed analysis of the early works of Nathanial Hawthorne, math would focus on theorems not normally covered but not overly challenging, history would focus on seldom-told tales of the host state or the nation or world. The host state would then teach intensely to these specialized standards, knowing that its own students could master them and students in other states — receiving a completely different curriculum — would perform poorly. It would be neither a “race to the top” nor a “race to the bottom,” but rather a “race to the trivial.”

This proposal also suffers the same problem that a single set of national standards would suffer: it would force all students of a given age to march through their state’s curriculum at the same pace, denying the obvious reality that kids of the same age learn the various subjects at different paces. Shackling them together into a scholastic chain-gang is not sound pedagogy.

What is encouraging about this proposal, though, is that it attempts to marshal both competition and incentives in pursuit of improved performance. Clearly, it’s on the right track. But why reinvent the wheel? We already HAVE a system that has proven, over centuries, to be able to effectively combine competition, freedom, and incentives in pursuit of innovation and excellence: the free enterprise system.

School systems organized along free market lines dramatically outperform all others – especially those which are most closely overseen, and run, by the state. We just need to figure out how to bring a free and competitive education marketplace within reach of all students.