Abstract
We develop a conceptual framework that links executive compensation incentives to the external risks and returns generated by the firm but borne by society. Recent advances in measuring liquidity creation (Berger and Bouwman, 2009) and systemic risk (Acharya, et al. forthcoming) allow us to estimate our framework for U.S. commercial banking companies. We find that CEO pay-performance incentives reduce both positive liquidity creation externalities and negative systemic risk externalities, while pay-risk incentives increase both externalities. Our findings infer a tradeoff for bank regulators: Restrictions on executive pay aimed at reducing systemic risk likely necessitate a reduction in system-wide liquidity creation.
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