Do Debt-based Incentives Lower Bank Systemic Risks?

Abstract

The outbreak of the 2008 international financial crisis underlines banking system instability, and the improper CEO compensation incentive plans are generally regarded as a deep cause. Hence, US, UK, EU etc, all issued schemes to reform bank CEO compensation, among which the debt-based incentives, such as deferred compensation and bonus recovery, are the important measure. In February of 2010, China Banking Regulatory Commission （CBRC） also released Guidelines for Robust Compensation Supervision of Commercial Banks”, clearly requiring commercial banks to enact the alike debt-based incentives. This practice has linked risk costs and risk deduction directly with CEO compensation, and as a result, compensation mechanism can fully play the constraint role in risk prevention. Existing literature on effects of debt-based incentives centers around the risk taking at individual banking level, and proves that debt-based incentives are helpful to the achievement of benefit consistency between CEOs and creditors, and the alleviation of benefit conflicts between stake-holders and creditors, thus decreasing banks’ downside risk, from perspectives of hedging decisions, payment policies, earnings management, credit allocation and so on. However, a key limitation lies in that these studies do not further explore the impact of CEO debt-based incentives on bank systemic risks. Then, whether or not debt-based incentives can lower bank systemic risks is still not known, and moreover, if so, what on earth are the influencing channels? Answers to those problems are of great practical significance to the implementation of compensation reform scheme and the forestalling of systemic risks. By collecting a sample data of Chinese listed banks from 2008 to 2015, this paper firstly applies CoVaR approach to measure each bank’s systemic risks, then builds up the unobserved effects panel model to analyze the direct effect of debt-based incentives on bank systemic risks, and finally constructs a pair of channel-effect system equations to further elaborate the indirect effect. Measurement results tell us that, no matter in crisis times or during stationary periods, banks show steady differences in systemic risks. Generally speaking, systemic risks are high in large-scaled state-owned banks or joint-stock banks, such as the Industrial and Commercial Bank of China, Pudong Development Bank, China Merchants Bank, China Construction Bank and China Industrial Bank, while those are low in small-scaled city commercial banks, such as Bank of Ningbo and Bank of Nanjing. In addition, volatility analysis of systemic risks discloses remarkable heterogeneity among banks, namely systemic risk of China Merchants Bank is the most volatile and that of Bank of Nanjing the least volatile. As to the empirical results, the main points are as follows. Firstly, CEO debt-based incentives can significantly deter banks’ systemic risks after controlling elements such as bank characteristics, corporate governance features and economic conditions. By implementing inside debt-based incentives in the form of deferred compensation, it helps to strengthen CEOs’ precautionary consciousness on bank risks. The logic behind this is that debt-based incentives can effectively mitigate the principal-agent conflict, thus reducing CEOs’ excessive risk taking activities and bank risk transfer possibility. Secondly, debt-based incentives lower bank systemic risks mainly through the decrease in maturity mismatch between banks’ assets and liabilities and the increase in banks’ non-interest income, especially commission and fees. On the one hand, a reduction in maturity mismatch would inhibit liquidity risk and default risk, thereby weakening inter-bank correlation and risk contagion. On the other hand, the enhancement of non-interest income would raise income stability, thereby alleviating the impact of systemic shocks. Lastly, the channel effects of financial derivatives are not significant, possibly because China’s financial derivative market started too late and the banking institutions are too cautious to intervene in it too much. This paper contributes to the existing literature in two aspects. In the first place, it fills the gap in disclosing the relationship between CEO debt-based incentives and bank systemic risks, and thus provides direct support for the optimization of compensation mechanism design. In the second place, it comprehensively studies the influencing channels of CEO debt-based incentives on bank systemic risks from perspectives of maturity mismatch, non-interest income and financial derivatives, and thus expands horizons for prudential regulation.