As a hedge fund manager once said to me, "Stock options don't make CEOs long their company's fortunes, they make CEOs long the volatility of their company's fortunes." If you are interested in incentive compatibility, you make CEOs put up their personal wealth and give them restricted stock.
Paul Krugman writes:
Their own private S&Ls: Floyd Norris had an interesting piece on Friday on the effects of paying executives largely in stock options; it confirms suspicions I’ve had in the past. Floyd doesn’t put it this way, but the research he describes basically says that big options grants give CEOs the same incentives that deregulation plus deposit insurance gave S&Ls in the 1980s....
[I]magine a CEO with a huge option package, but one that’s well out of the money — that is, it’s worthless if the stock price stays where it is or goes down, but might be worth a huge amount if the stock goes up a lot. Well, he’s in the same position as an S&L owner. It’s in his interest to make very risky plays, that might drive up the stock price but probably won’t. After all, it’s heads he wins, tails the stockholders lose. And a bit of fraud to pump up the stock price, just long enough to cash in, would make sense too.
Sure enough, that’s exactly what happened. In the early days of the explosion in CEO paychecks, Michael Jensen and Kevin Murphy famously claimed that it was all part of giving executives an incentive to be entrepreneurial:
On average, corporate America pays its most important leaders like bureaucrats. Is it any wonder then that so many CEOs act like bureaucrats rather than the value-maximizing entrepreneurs companies need to enhance their standing in world markets?
So we started paying CEOs like S&L owners instead - and they started acting like riverboat gamblers.