Bank monitoring and CEO risk-taking incentives

Abstract

This paper investigates whether monitoring by bank lenders affects CEO incentives of borrowing firms. We find that an increase in bank monitoring incentives significantly reduce the sensitivity of CEO wealth to stock return volatility (Vega). The results are more profound when bank lenders are more powerful and reputable and have a prior lending relationship with the borrowing firms. Additionally, Vega decreases after financial covenant violations and increases when bank lenders have offsetting equity stakes in borrowing firms. The reduction in Vega due to bank monitoring has some real effects on borrowing firms’ corporate policies. These results together suggest banks have a unique role in monitoring and shaping CEO incentives to mitigate the risk-shifting incentives of firm managers.