How Does Executive Compensation Affect Bank Risk Taking: Evidence from FAS 123R

Abstract

We examine how management compensation policies affect bank risk taking in mortgage lending using exogenous variation in stock option grants generated by FAS 123R, which requires all firms to expense options. Using a difference-in-differences approach, we find that banks that did not expense options before FAS 123R (treated banks) significantly decrease approval rates of risky mortgage applications after FAS 123R relative to banks that did not grant stock options or voluntarily expensed their stock option before FAS 123R (control banks). We also find that the treatment effect is concentrated in large banks, suggesting that managers’ risk-taking incentives at large banks are more sensitive to option compensation. Finally, we show that treated banks are more likely than control banks to reduce their exposure to risky mortgages through securitization after FAS 123R.