Executive compensation in banks: insights from CEO equity incentives and securitization transactions

Abstract

This paper investigates whether CEO equity incentives promote risk-taking activities in the financial industry. Prior research shows that, during the recent credit crisis, banks whose CEOs had high equity incentives performed significantly worse than banks whose CEOs had low equity incentives. A possible explanation for this result is that the incentive to boost stock price induced CEOs to take risks that turned out to be extremely costly. Focusing on securitization transactions that were among the fundamental causes of the financial crisis and using a sample of US financial institutions, the paper provides evidence that banks whose CEOs had high equity incentives engaged in securitization transactions to a greater extent than did financial institutions guided by CEOs with low equity incentives. Moreover, the paper shows that CEOs with high equity incentives securitized riskier loans than did CEOs with low incentives. This study helps to clarify the role of equity-based compensation in promoting risk-taking behaviors in banks.

Appendices

Appendix 1

CEO equity incentives (Delta) are measured as the change in dollar value of a CEO’s wealth per 1 percent change in stock price using the following formula:

$$Delta = \, 0.01\;*\;{\text{PRICE}}\;*\;\left( {{\text{SHARES}}\; + \;{\text{DELTA}}\_{\text{OPTION}}\;*\;{\text{OPTIONS}}} \right)$$

Here, PRICE is the fiscal year-end company share price, SHARES is the number of shares held by the CEO as of the fiscal year-end, OPTIONS is the number of options held by the CEO as of the fiscal year-end, and DELTA_OPTION is an estimate of the delta of the CEO’s option portfolio. The delta of an option measures the rate of change in the option value with respect to changes in the underlying stock price. A delta of .07 means that a 1 percent change in stock price would cause a .07 percent change in the value of the option. Therefore, the higher the delta, the greater the executive’s incentive to boost the stock price. The value of the delta depends on the structure of the underlying contract.

To get DELTA_OPTION, I followed Core and Guay’s (2002) methodology in estimating the stock option’s sensitivity to stock price based on the Black and Scholes (1973) formula for valuing European call options, modified to account for dividend payout (Merton 1974).

$$Option\;Value = [Se ^{-dT} N\left( Z \right){-}Xe^{{{-}rT}} N\left( {Z - \sigma T^{(1/2)} } \right],$$

(3)

where Z = [ln(S/X) + T (r − d + σ²/2]/σT^(1/2), N = cumulative probability function for the normal distribution, S = price of the underlying stock, X = exercise price of the option, σ = expected stock-return volatility over the life of the option, r = risk-free interest rate, d = expected dividend yield over the life of the option.

The sensitivity with respect to a 1 percent change in stock price is defined as:

$$[\delta \left( {option\,value} \right)/\delta \left( {price} \right)\,*\,\left( {price/100} \right) ]= e^{ - dT} \,*\,N\left( Z \right)\,*\,\left( {price/100} \right)$$

(4)

The sensitivity with respect to a 0.01 change in stock price volatility is defined as:

$$\left[ {\delta \left( {option\,value} \right)/\delta \left( {volatility} \right)} \right]\,*\,0.01 = e^{ - dT} \,*\,N^{{\prime }} \left( Z \right)\,*\,ST^{1/2} \,*\,0.01,$$

(5)

where N′ is the normal density function.

Appendix 2

Figure 1 provides an example of the information banks disclose regarding securitization transactions. This table was included in Bank of America’s 2007 Annual Report under in Note 8, “Securitizations.” It shows that, as of December 2007, Bank of America managed a portfolio of loans and leases worth $985,780 million (measured at both the historical cost and fair value), of which $109,436 million was managed in securitizations.