Debt valuation adjustments and executive compensation

Abstract

This paper investigates the relation between debt valuation adjustments (DVAs) and top executive compensation in the banking industry. DVAs arise from changes in fair value of liabilities associated with changes in a firm’s own credit standing, and have become a significant income component for some banking companies. We present three major findings. First, we find that executive compensation is positively related to pre-DVA income and stock returns, which is consistent with the relationships suggested by prior literature (e.g., Lambert and Larcker, 1987; Sloan, 1993). However, our second finding shows that top executives are penalized not only for DVA losses but also for DVA gains. This finding is consistent with the notion that efficient compensation contracts should be conservative and incorporate DVA losses immediately, while DVA gains could in fact be economic losses because the firm’s credit standing has declined. Consistent with this notion, we show that top executive compensation decreases in banks with increased Credit Default Spread (CDS) premiums (a proxy for declined own credit rating), but the explanation power of CDS is subsumed by DVA once DVA is added to the model. This finding implies that the compensation committees of banks penalize executives for DVA gains to discourage them from incurring economic losses resulting from credit rating deterioration.

Keywords: Debt Valuation Adjustments, DVA, Executive Compensation