Bank Executive Compensation Structure, Risk Taking and the Financial Crisis
48 Pages Posted: 24 Aug 2010 Last revised: 14 May 2014
Date Written: February 25, 2014
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.
Keywords: Executive compensation, Moral hazard, Bank risk, Financial crisis
JEL Classification: G34, G01, G32, G21, G28
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