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Dedoro, Mary Antoniette P. ACT 152 ² B75


The risk of poor compensation structure
Various factors have contributed to the ongoing global financial crisis. But how could the world's most sophisticated banks and financial institutions stake the lives of their businesses on collateralized debt obligations and mortgage-backed securities? One of the underlying reasons lies in the executive·s compensation structure.

But what we are going to discuss here is the role of executive compensation structure to the financial crisis. The problem with the usual compensation is that it focuses more on short-term financial results rather than long-term value and stability.subprime borrowers started defaulting on their mortgages). Accordingly. etc. there is a link between the typical compensation scheme of executives and the financial crisis. Because of this higher risk. the decision making based primarily on shortterm considerations damages the ability of public companies to sustain superior long-term performance. a good compensation package should lead to an effective corporate performance. the value of the equity based compensation is positively related to the underlying stock variance and therefore motivates executives to take higher levels of risk which are aligned with the shareholders interest. Typical compensation plans are sensitive to assets risk. It may lead a manager to take actions that reduce the variability of returns and firm risk. the quality of borrowers steadily declined and the chance of default rose dramatically which led to bankruptcy of many financial institutions and bailout of some others. mortgage compensation model. they make decisions that are favorable for the short term even though it is too risky for the future since most compensation packages would include excess payments to corporate executives who met short-term targets. Truly. But it must be well-thought out since the compensation in the form of salary and bonus may influence an executive in different ways. As a consequence.Executive·s compensation role in the global financial crisis Executive·s compensation role in the global financial crisis THE RISK OF POOR COMPENSATION STRUCTURE There are many factors that directly and indirectly caused the current global financial crisis. Executive compensation plans can lead to two socially undesirable outcomes: excessive risk taking at one extreme and complete freeze of risky activities (new lending) on the other. cash flow. To further explain. Appropriate performance measure should be adeptly reviewed in determining whether it is aligned to the company·s long-term goals. Aligning performance to one·s organization's goals and objectives is critical to the Page 1 . Of course. etc. CEOs may be more risk inclined or risk averse depending on what it could affect his compensation Several methods of performance measurement like return. macroeconomic conditions like low interest rates and trade deficit. Some of it are the problems with unregulated derivatives or securitization of mortgages and credit card debt (does not provide protection against systematic risk . Because of the executive·s self-interest. Perhaps the problem with these compensation structures is the performance measure that determines whether they have performed well or not and deserve an incentive or not. are used by firms and recent studies support that management's decisions and performance can be influenced by the managerial compensation plan. executive pay and bonuses. the executives would choose an optimal volatility for the firms· assets that would maximize the value of their compensation. stock price. Such compensation package would incentivize the executives to take excessive levels of risk or none at all because of the concave relationship between assets volatility and the value of total compensation.

2C_executive_pay_and_bonuses The performance measures should be aligned with their definition of success and such measures should drive the management with right Page 2 .jsp?id=1202426091714 http://www.wikipedia. On the other side. The compensation·s compensation role in the global financial crisis organization's success. Sources: http://www.pdf http://en. So one has to bear in mind that compensation plan should support the achievement of the company·s performance and performance measures within the program. lack of alignment increases inefficiencies and risks and prevents optimal execution of the organizational needed to evolve to keep pace with the company·s dynamic business environment.