Abstract
It is widely accepted that managerial compensation packages contributed to the excessive risk-taking practices that led to the onset of the Great Recession (2007–2009). We argue that the relationship between managerial compensation and risk taking is procyclical. A given level of performance incentives may result in significantly lower firm risk when economy is in a systemic crisis because managers face an increased employment risk during economic downturns. Students of finance who will become policy makers or who will sit on compensation committees would benefit from realizing that in order to implement a given level of firm risk, managerial compensation packages may need to be adjusted according to the state of the economy.
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Acknowledgement
We thank Iftekhar Hassan, the Editor of the Journal of Financial Stability for his valuable comments. We are also indebted for useful comments and suggestion to Jens Hilscher, Antoni Vaello Sebastià, Catherine Mann, David Yermack, Dan Zhang, the Editor and referees, as well as seminar participants at Brandeis University, Williams College, the 2011 FMA Annual Meeting in Denver, 2012 EFA Annual Meeting in Boston, the Ackerman Conference on corporate governance in Bar Ilan University, and the conference on Teaching Finance at Turbulent Times at Heilbronn University. Alon Raviv thanks the Raymond Ackerman Family Chair in Israeli Corporate Governance for its support.
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Appendix: Baseline Values for the Model Parameters
Appendix: Baseline Values for the Model Parameters
Parameter | Notation | Base value |
|---|---|---|
Leverage ratio | LR | 0.95 |
Face value of debt | F | 100 |
Firm value | V | 102.15 |
Time to maturity | T | 1 |
Economic index volatility | σ S | 20 % |
Risk-free rate | r | 3 % |
Economic index value | S | 90–110 |
Crisis threshold | K | 100 |
Sensitivity of compensation to a 1 % increase of asset value above the strike price | α | 2 |
Sensitivity of compensation to a 1 % decrease in asset value below the value of debt | β | 1 |
Sensitivity of compensation to the joint event of a decrease in asset value below the value of liabilities in a financial crisis | γ | 2 |
Correlation between returns of the firm’s assets and the economic index | ρ | 0.8 |
The strike price of equity-based compensation | H | 105.57 |
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Raviv, A., Sisli-Ciamarra, E. (2016). Executive Compensation and Risk Taking: The Impact of Systemic Crises. In: Azarmi, T., Amann, W. (eds) The Financial Crisis. Springer, Cham. https://doi.org/10.1007/978-3-319-20588-5_9
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DOI: https://doi.org/10.1007/978-3-319-20588-5_9
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