Pay for Prudence, Not Profit

Boeing’s been in the headlines for all the wrong reasons in 2024. Following multiple safety issues with their airplanes, the company recently announced a revamp of employee bonuses by tying them to quality and safety benchmarks, not financial results.

To Associate Professor Salman Arif and his co-authors, this approach is another real-world example of the importance of paying for prudence. Their paper, published in the Journal of Accounting and Economics, is the first academic research study to propose and explain this concept.

“We looked at compensation of bank executives, a rich dataset that clearly shows how this approach works over a long period of time,” explains Arif of his work with John Donovan at the University of Notre Dame, Yadav Gopalan at Indiana University’s Kelley School of Business, and Arthur Morris at the Hong Kong University of Science and Technology.

The researchers define “pay for prudence” as targets that reward managers for lowering credit risk, including “receiving satisfactory regulatory ratings, reducing non-performing loans, minimizing loan losses, or maintaining high credit quality.” They found that prudence-based targets “complement traditional risk-taking incentives and are effective in fostering prudent behavior by managers, which lowers bank risk and reduces the chance of bank failure.”

Using textual analysis of the compensation disclosures of all publicly traded banks in Def 14A filings going back to 2001, the researchers identified “compensation contract terms, performance vesting provisions, and bonuses that are contingent on prudence-related targets identified using a library of prudence-related terms from the Federal Reserve Board’s Commercial Bank Examination Manual.”

The results reveal a significant fraction of banks have used pay for prudence over the last two decades. In fact, over time there has been a shift from vague references to prudence in compensation plans to concrete and detailed prudence-based targets, reaching roughly 20 percent of banks by 2017.

Importantly, for many banks these practices pre-date the financial crisis of 2007–2009 and align with required changes to the 14A filings.

“We highlight that traditional equity-based incentives for risk-taking can lead bank managers to increase leverage and systemic risk, exactly the types of risks that regulators find most troubling,” says Arif. “Our findings suggest that bank boards should design compensation contracts to consider both shareholders’ desire to encourage value-enhancing risk while also discouraging imprudent risk-taking and the potential for costly regulatory intervention.”

Further, the authors say the recent failures of Silicon Valley Bank, Signature Bank, and First Republic Bank “emphasize the importance of our study to researchers and regulators.” Why? They find that prudence terms are “conspicuously absent” at Silicon Valley Bank, and that “while First Republic Bank’s proxy statements include concrete [prudence] targets, Signature Bank’s proxy statements only provide vague discussion of it.”

“This suggests that pay for prudence is a key step in the right direction but not a panacea,” says Arif. “It raises important questions for future research about the role of boards and compensation practices in mitigating the risks associated with bank failures.”