Israel capped CEO pay for banking execs at $1 million. Its unique experiment could work here, too

Posted on January 14, 2022 in Debates

Source: — Authors: – Business/Opinion
Jan. 14, 2022.   By Amir Barnea, Contributing Columnist

Five years in, Israeli banks prosper, the economy is doing just fine, the financial system is stable as ever, and the CEOs of Israel’s big banks have stuck with their jobs, Amir Barnea writes.

The CEOs of Canada’s big five banks made an average $11.4 million in total compensation in 2020, according to a recent report published by the Canadian Centre for Policy Alternatives. This figure is similar to their average pay in 2019, which stood at $11.7 million.

Now imagine that one day, almost out of the blue, legislators in Ottawa imposed a maximum cap of $1 million on banking executives’ total compensation, citing inequality, unjustified excessive pay, and implicit bailout from the government in times of crisis.

What would the business news headlines be?

Free-market advocates and bank lobby groups would surely argue that it would be impossible to find the talent to run the banks; that the banks’ performance and the entire stability of our financial system would suffer; and that this extreme interference with how “the market” sets CEO pay is a huge mistake.

Well, it turns out that a scenario like this has already happened. Not in Canada, but in Israel, which has a remarkably similar financial industry, dominated by five large, publicly traded local banks.

Five years ago, the Israeli Parliament passed legislation that caps the annual compensation of executives in Israeli financial institutions such as banks and insurance companies at either 2.5 million shekels ($1 million Canadian) or 35 times the salary of the lowest-paid, full-time employee.

When the law was passed, some banking executives were making as much as 8 million shekels ($3.2 million Canadian) a year, hence they were up for a dramatic cut in pay of almost 70 per cent.

Israel’s “Compensation for Officers of Financial Corporations Law” commenced a huge debate in the country, drawing fierce objections from those against it.

One publicist on the popular Maariv news website went as far as saying: “Under the camouflage of reducing disparities, the executive pay limitation law is populist, dangerous, threatening and undermining democracy, and could lead to the destruction of the private economic sector, and to a communist regime.”

But despite the doomsday predictions, the sky didn’t fall.

A group of four Israeli business professors who analyzed financial institutions affected by the law during its first three years of implementation found that the share prices of those financial companies increased on average by about 2 per cent; that there was no increase in the rate of departures of senior executives; and that there was no decrease in the accounting performance of the banks. The results were published in 2020 in the Journal of Banking and Finance.

Five years into this unique experiment — which has no equivalent elsewhere in the world — Israeli banks prosper, the economy is doing just fine, the financial system is stable as ever and, after a few changes in leadership, the CEOs of Israel’s big banks have stuck with their jobs, albeit making only a “starving salary” of about $1 million (Canadian).

Hence, it seems like the “extreme” and “radical” law did no harm. On the contrary, some banks have increased the salaries of the lowest-paid employees to meet the law’s requirement that the CEO’s salary not be higher than 35 times the bottom one.

To be fair, the law has created a few anomalies. For example, since it is applied only in Israel, some managers of subsidiaries of Israeli banks (for example, Bank Leumi, NY, USA) are making two to three times the pay of the CEOs they report to.

In addition, since CEOs are receiving a fixed salary, their contracts lack any incentive-based compensation such as bonus, stocks or options, which arguably doesn’t align them perfectly with shareholders.

The Israeli natural experiment is an extremely important lesson in the general debate about executive compensation. Over the years, the ratio between those who hold the top jobs and regular employees has gone up tremendously. Justifications for this were always based on arguments that CEO pay is set in a competitive market.

The reality, however, is different. CEO pay has no equilibrium and continues to ratchet up endlessly. When a company is looking to hire a new CEO or to set pay, its board will typically use the services of an executive compensation consulting firm, which is a big industry in itself.

In most cases, consultants will recommend offering the designated manager a higher-than-average “competitive” salary package. The consultants themselves are often compensated proportionally to the remuneration package. Therefore, all players have an incentive to inflate pay. Over time, it became excessive.

Another process, which is happening simultaneously, is that executives themselves have gotten used to the inflated levels of pay, and believe they genuinely deserve them. After all, they do carry heavy responsibilities, and work long hours, and all the other executives are also receiving very high pay. Shouldn’t they participate in the party?

For too long we’ve been brainwashed by free-market myths about CEO pay. The natural experiment in Israel has refuted them.

CEOs shouldn’t make hundreds of times more than their employees and would agree to perform the same job for a fraction of current pay levels as they did decades ago. As it turns out, all we have to do is dare to challenge them.

Amir Barnea is an associate professor of finance at HEC Montréal and a freelance contributing columnist for the Star.

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