Abstract
This paper examines whether the systemic risk of financial institutions is associated with the risk-taking incentives generated by executive compensation. We measure managerial risk-taking incentives with the sensitivities of chief executive officer (CEO) and chief financial officer (CFO) compensation to changes in stock prices (pay-performance sensitivity) and stock return volatility (pay-risk sensitivity). Using data on large U.S. financial institutions over the period 2005–2010, we document a negative association between systemic risk and the sensitivities of CEO and CFO compensation to stock return volatility. However, our results also demonstrate that financial institutions with greater managerial risk-taking incentives were associated with significantly higher levels of systemic risk during the peak of the financial crisis in 2008. We further document that the relation between pay-performance sensitivity and systemic risk is essentially nonexistent. Overall, our empirical findings indicate that the association between managerial risk-taking incentives and banks’ systemic risk is ambiguous and is not stable over time.
Highlights
“Compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability.” Chairman Ben S
Do compensation-based risk-taking incentives of the top executives increase the riskiness of financial institutions and the level of systemic risk? In this paper, we aim to address this question by empirically examining the linkage between systemic risk and the sensitivities of chief executive officer (CEO) and chief financial officer (CFO) compensation to changes in stock prices and stock return volatility
The control variables are defined as follows: size of the financial institutions (Size) is measured as the total assets, Capital ratio is the ratio of equity to total assets, Return on assets is the ratio of net income to total assets, Loans to assets is the ratio of net loans to totals assets, Loan growth is the percentage change in loans from year t − 1 to year t, Deposits to assets is the ratio of deposits to total assets, and Non-interest income is the ratio of non-interest income to total income between the systemic risk measures and the deltas and vegas of the top executives suggest that financial institutions with greater managerial risk-taking incentives are generally associated with lower levels of systemic risk
Summary
“Compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability.” Chairman Ben S. The documented positive association between CEO and CFO risk-taking incentives and systemic risk during the severe market turmoil in 2008 may indicate that financial institutions with greater compensation-based managerial risktaking incentives were taking more risk before the crisis in order to maximize shareholder wealth, and that these risks were materialized and exposed during the financial crisis This interpretation of our results is broadly consistent with the previous studies which suggest that banks with more shareholder-focused corporate governance structures were taking more risk before the crisis (e.g., Fortin et al 2010; Erkens et al 2012; Peni and Vähämaa 2012).
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