Impact of compensation structure and managerial incentives on bank risk taking

Abstract

We analyze the impact of managerial compensation structure in publicly-traded banks on their risk taking behavior, specifically the changes in risk taking through the changing regulatory environment for these banks. We perform a simulation analysis to study the impact of the interaction between regulatory changes and competitiveness in banking on managerial compensation, and in turn their joint impact on a bank's riskiness. The three hypotheses we examine using the simulation analysis are, (1) increase in competitiveness after deregulation results in higher levels of risk for banks, (2) regulatory changes can result in change in the composition of managerial compensation, which creates an environment of incentives for enhanced risk taking, (3) regulatory changes accompanied by certain governance or managerial compensation controls can bring prudence in the risk taking behavior. The simulation model allows isolating each factor for its impact on a particular bank's riskiness due to the regulatory changes. This impact is then correlated with the governance characteristics of the bank. We observe that competition uniformly increases the risk in firm value and shareholder-equity of all the banks, more severely for some than others. Its effect on change of firm value through regulatory changes observed is opposite from its effect on shareholder-equity for some banks. Change in competition combined with change in managerial compensation captures significantly more of the increased risk in firm value and shareholder-equity. Lastly, the governance characteristics show that risk differential between competition alone and competition combined with compensation is low for banks with good governance.