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Bank executive compensation structure, risk taking and the financial crisis

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Abstract

This paper investigates (1) how the composition of executive compensation is related to a bank’s incentive to take excessive risk, (2) whether executive compensation in larger banks, especially the too-big-to-fail (TBTF) banks, induces more severe moral hazard behavior, and (3) how the relation between bank executive compensation and risk taking changes before and during the recent financial crisis. We find that bank risk measured by the Z-score and the volatility of stock returns increases with both the percentages of short-term and long-term incentive compensation. However, greater proportion of incentive pay decreases the likelihood for a bank to become a problem or failed institution. This result holds for the periods before and during the recent financial crisis. The distress-mitigating effects of incentive compensation are further confirmed by our finding that both the proportions of bonus and long-term incentives are positively related to bank valuation and performance. Interestingly, we find that TBTF banks experience greater risk taking (lower Z-score) and are more likely to be in financial distress than smaller banks. However, greater incentive compensation in TBTF banks helps reduce their insolvency risk relative to smaller institutions.

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Notes

  1. One of the reasons for this argument is that the risk for bank executives to lose their jobs may be high enough to offset their compensation-induced incentives to take excessive risk. Amihud and Lev (1981) argue that managers’ risk-reduction activities may arise from their employment risk.

  2. As reported in the Economist article “Attacking the corporate gravy train” on May 28, 2009, some well-known institutions such as Morgan Stanley made base salaries a bigger percentage of overall compensation in response to criticism of their compensation structure. The practice of increasing base salaries while reducing performance-related payments after the credit crisis was also documented in the New York Times article “As profits wane, Wall Street braces for new layoffs” on June 16, 2011. However, there is a lack of evidence that this change is in the right direction to enhance the institutions’ risk management and financial performance.

  3. John et al. (2010) also use the ratio of non-performing loans to total loans to measure the riskiness of bank assets.

  4. These risk measures are similar to those constructed in Laeven and Levine (2009). They include the standard deviation of stock returns, standard deviation of return on assets, and the Z-score is calculated as (ROA + Capital)/σ(ROA), where σ(ROA) as the standard deviation of quarterly return on assets (ROA), and Capital is the capital to asset ratio. The Z-score measures the distance from bank insolvency.

  5. Fahlenbrach and Stulz (2011) use 2006 bank CEO compensation and ownership data to examine whether bank performance during the recent credit crisis is related to the CEO incentives before the crisis. Fortin et al. (2010) examines bank risk taking using data from the pre-crisis period of 2005–2006.

  6. PPS is defined as the dollar change in compensation in response to a dollar change in firm value, as measured by annual share price appreciation and dividends (Jensen and Murphy 1990).

  7. We focus on discussing the executive compensation in the banking industry because of the differences between regulated industries and other industries. For instance, Chang et al. (2012) find that CEOs’ stock ownership and pay-performance sensitivity in regulated industries have distinct responses to changes in regulatory environment from other industries.

  8. Smith and Watts (1992) maintain that, if a firm’s managers are risk averse and cannot diversity away their compensation risk, the higher the firm’s risk, the higher the risk of the managers’ compensation, and the higher the managers’ equilibrium compensation.

  9. Crawford et al. (1995) define the low-capitalization banks as the ones with book value of capital to assets ratios in the lowest quartile of their sample, and the high-capitalization banks as the ones that are not low-cap banks.

  10. For robustness purposes, we have estimated all our regressions with either TDC1 or TDC2 as the measure of total compensation. The results hold.

  11. Because Execucomp reports the amount of equity, stock options, or deferred compensation separately for only about one sixth of the observations in our sample, we do not estimate the regressions using these individual compensation components as regressors.

  12. Although equity-based compensation can be either short-term or long-term incentives depending on the vesting period and the unwinding limit of the stocks and options (Bebchuk and Fried 2010), it is reasonable to assume that overall, the Long-Term Incentives variable captures greater long-term compensation compared with base salary and bonus.

  13. John et al. (2010) also use the ratio of non-performing loans to total loans to measure the riskiness of bank assets.

  14. The failed bank list is obtained from http://www.fdic.gov/bank/individual/failed/banklist.html.

  15. Federal Reserve Bank of St. Louis published a timeline of events and policy actions during the recent financial crisis (see http://timeline.stlouisfed.org/). The first event listed is the Freddie Mac’s announcement that it would no longer buy the most risky subprime mortgages and mortgage-backed securities in February 2007. The mortgage delinquencies and foreclosures rose sharply after US house prices peaked and began to fall in early 2007. We therefore use 2007 as the starting year of the recent financial crisis.

  16. The results are qualitatively the same if we use the log transformation of the CEO compensation variables in eq. (1).

  17. We use franchise value and charter value interchangeably in this paper.

  18. The greater bonus to the CEOs of the TBTF banks may have a tax explanation. The Internal Revenue Service (IRS) Code Section 162(m) precludes a deduction by any publicly held corporation for compensation paid to any covered employee to the extent that the compensation for the taxable year exceeds $1 million. However, this $1 million limit does not apply to qualified performance-based compensation. If larger BHCs have higher CEO compensation, they are more likely to pay their CEOs with greater performance-based compensation to avoid this tax deduction limit.

  19. Note that we do not include Crisis as an explanatory variable separately since our regressions include year dummies and as a result, these dummy variables fully represent the Crisis variable.

  20. In the regressions presented in Tables 5 and 6, we do not include ROE as a control variable since Ret and ROE are highly correlated and conceptually measure the same thing. We were required to include Ret in Tables 5 and 6 to ensure that the empirical specifications of the tests involving PPS are well defined.

  21. Wang (2012) finds that for a sample of industrial firms, board size is negatively related to the level of risk taking of the companies. However, because board size could be an endogenous variable determined by firm characteristics that explain executive compensation, we do not include it as a control variable here.

  22. These options are exercisable within or will become exercisable within 60 days.

  23. Houston and James (1995) identify institutions with CAMEL ratings of 3, 4, and 5 as ‘problem’ or ‘potential problem’ banks. They examine the mean difference in salary, option holdings and stock holdings between banks not receiving a CAMEL downgrade and banks receiving a downgrade to a 3 or a 4 around the CAMEL change. However, they do not examine whether banks’ executive compensation structure affect CAMEL rating change in a multivariate regression framework.

  24. Because adding the CEO pension payment variable substantially reduces the number of observations for the logit regressions on financial distress, we report the results from the logit model without this variable in Table 8.

  25. Lam and Chng (2006) find a convex relation between Tobin’s q and executive stock option grants for a sample of non-financial firms. Nonetheless, they report that the majority of the firms that grant more executive stock options tend to have higher Tobin’s q.

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Acknowledgments

We thank Senay Agca, Mufaddal Baxamusa, John Boyd, Zhongdong Chen, Rebel Cole, Anand Jha, Hamid Mehran, and Fernando Moreira for helpful comments and suggestions. We are especially thankful to the editor C.F. Lee and two anonymous referees. We are grateful to the participants of Financial Management Association Meeting 2011, Financial Management Association Europe Meeting 2011, International Finance and Banking Society Conference 2011, Multinational Finance Society Conference 2011, and Suffolk University Research Seminar. Any remaining errors are, of course, our responsibility.

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  1. Sawyer Business School, Suffolk University, 8 Ashburton Place, Boston, MA, 02108, USA

    Lin Guo, Abu Jalal & Shahriar Khaksari

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  1. Lin Guo
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Correspondence to Lin Guo.

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Guo, L., Jalal, A. & Khaksari, S. Bank executive compensation structure, risk taking and the financial crisis. Rev Quant Finan Acc 45, 609–639 (2015). https://doi.org/10.1007/s11156-014-0449-1

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