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Faculty Insights

Unpacking Dodd-Frank: Do Banks that Sell Assets Unintentionally Encourage Executives to Take Risks?

By Wisconsin School of Business

July 6, 2015

The 2010 Dodd-Frank Act was written to prevent a replay of the 2008 financial crisis by providing more oversight and regulation of the U.S. financial system, including asset securitization and executive compensation—considered by many to be the main causes of the crisis.
The law treats these two factors separately, but my co-authors, Jonathan Lipson of Temple University, Rachel Martin of the University of Wisconsin–Madison, Emre Unlu of the University of Nebraska–Lincoln, and I wanted to find out whether companies that securitize—sell assets such as mortgages or accounts receivable for cash—pay their executives more than those that don’t.

Ella Mae Matsumura
Ella Mae Matsumura, Professor of Accounting and Information Systems at the Wisconsin School of Business

We found no relationship between securitization and executive compensation in industrial firms. With banks, however, we found that securitization has a strong positive correlation with above-average executive compensation. In fact, for banks of the same size, one that securitizes pays its CEO $400,000 more on average than one that does not securitize.
Why are CEOs earning so much more at securitized banks? Are they merely being commensurately rewarded for superior performance? Our research says no.
Some argue that executives deserve a lot of money because the labor market for good executives is thin, and if their financial rewards are tied to the stock prices of the company, they are more likely to have their investors’ interest at heart.
Our research shows that the drive for short-term gains could encourage excessive risk taking. We compared financial performance of securitized and non-securitized banks and found that securitized banks performed better in the short term but not over time.
In other words, securitization is associated with improved short-term financial performance and thereby creates the appearance of value, but it may actually encourage risks that harm the firm in long run.
Dodd-Frank applies to all securitizations, but the law should pay more attention to originating banks because, as our research shows, that’s where the problem begins. Dodd-Frank may therefore over-regulate other firms involved in securitization, while under-regulating those with important responsibility for the financial crisis.