Executive Short-Term Incentive, Risk-Taking and Leverage-Neutral Incentive Scheme

Abstract

In 23 out of 26 U.S. industries, the annual CEO bonus is larger than the annual salary, suggesting that the bonus strongly affects the CEO’s decisions. As the high leverage of financial institutions is often blamed for the 2008 financial crises, in this study we focus on leveragre as a factor determining risk, particularly in finnacial institutuions. The typical bonus scheme is not a leverage-neutral bonus scheme (LNBS), as the agent’s optimal policy is to employ a corner solution: either zero or exteremely high leverage. Thus, consistent with Ross (2004), the bonus scheme does not neccesarily induce the agent to take greater risks. However, although more leverage is not preffered by allpreferences, in most cases it is preffered. Thus, we suggest a combination of incentive parameters, which makes the agent indifferent to leverage, thereby preventing conflict beween the agent and the principal (stockholders).