Five years since the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act meant to prevent a repeat of the financial crisis of 2008 by reducing risky securitization (sales of financial assets) and reigning in excessive CEO compensation, the law may not be as effective as lawmakers intended.
A new study from the Wisconsin School of Business suggests that Dodd-Frank’s regulations fail to account for the link between securitization and CEO compensation and may be targeting the wrong firms, allowing some of the banks that originate risky financial transactions to escape effective regulation.
Ella Mae Matsumura, professor of accounting and information systems at the University of Wisconsin-Madison’s Wisconsin School of Business, Rachel Martin of the Wisconsin School of Business, Jonathan C. Lipson of Temple University, and Emre Unlu of the University of Nebraska-Lincoln found that securitizing banks paid their CEOs, on average, twice as much as non-securitizing banks, $3.23 million vs. $1.6 million per year. Holding other factors constant, in looking at two banks of roughly the same size, the one that securitizes paid its CEO, on average, more than $400,000 more than the ones that did not. However, the shares for those securitizing banks performed no better than the non-securitizing banks and during the financial crisis, those banks received more than twice as much government support under the Troubled Asset Relief Program (TARP) as non-securitizing banks.
“Dodd-Frank treated securitization and compensation as unrelated phenomena, but our study shows there is an important link between the two, and that the drive for short-term gains can encourage long-term risks,” says Matsumura, professor at the Wisconsin School of Business, ranked 11th nationally among top accounting programs. “The law also differentiated between ‘originators’ and ‘securitizers’, imposing regulations on the latter group, even though the risks in securitization start with the originators.”
Matsumura adds, “Our research suggests that Dodd-Frank not only overlooked the link between securitization and compensation that may create incentives for taking on risk, but it missed a critical step in the process—identifying the firms where the transactions and risks begin.”
Dodd-Frank contains extensive provisions on both securitization and executive compensation, most notably measures requiring “securitizers” to retain risk (so-called “skin in the game” rules) and giving regulators the power to “claw back” excessive pay. While having the good intent of better aligning incentives in securitization, they are indirect and highly complex in the 849-page law.
Matsumura and her co-authors suggest that to achieve the Dodd-Frank goals of systemic stability and accountability, the best answer may be simpler rules that are better-tailored to account for the relationship between banks originating some of the worst securitizations and their CEO salaries.
“Rather than further complicate environments that are already highly complex, regulators should consider the incentives created by transactions in which banks engage, and the effects of those incentives,” said Matsumura. “We hope any future regulation considers the pattern in securitization and compensation we have identified here as a means of making borrowing and investing safer for all Americans.”
Matsumura’s research paper, “The Pattern in Securitization and Executive Compensation: Evidence and Regulatory Implications” will appear in the Stanford Journal of Law, Business & Finance.