CEO Remuneration and Bank Default Risk: Evidence from the US and Europe

Abstract

We analyze the impact of incentive mechanisms embedded in executive remuneration contracts on the risk choices made by bank CEOs. For a panel of US and European banks, we employ the Merton distance to default model to estimate how bonus payments and option holdings impact the level of bank default risk targeted by CEOs. We find that CEO cash bonuses reduce default risk, while stock options increase the preferred risk level. We argue that the convex payoff structure of stock options induces CEOs to shift risk to bondholders and regulators, whereas the (typically) non-convex payoffs linked to managerial bonus plans constrain managerial risk preferences. Further, we show that CEO pay promotes excess risk-taking predominantly in weaker regulatory environments and at financially distressed banks. Our results link executive compensation in the banking industry to financial stability and caution that any attempt to regulate compensation in banking needs to tie compensation practices to regulatory regimes and the riskiness of banks.

Keywords: banks, default risk, executive compensation

JEL Classification: G21, G33, J33