Executive compensation has leapt to the forefront of the debate surrounding the primary causes of the recent financial crisis. Numerous accounts in the popular press speak of greedy, self-serving bank executives who took on unnecessary and excessive risks that came close to bringing about the downfall of the financial system. Central to the narrative is the hypothesis that managerial equity compensation introduces the moral hazard for excessive risk-taking in the banking industry. Several academic studies articulate the view. Among them, Bebchuk and Spamann (2010) argue that the payoffs on bank executives’ option and stock holdings are tied to highly levered bets on the value of the banks’ capital, providing powerful incentives for excessive risk-taking. Can criticisms of unbridled executive compensation and excessive risk-taking in the banking industry be empirically validated? What are the channels through which executives increased risk?
This study finds that equity incentives can induce risk-taking beyond levels desired by regulators, and that these risks were in part manifested through lax lending standards. Several studies have also examined the relationship between CEO equity compensation and risk-taking in the banking industry, although the results have been arguably inconclusive. The lack of consensus can be attributed to two fundamental limitations surrounding the existing literature that are difficult to address. First, identification is difficult in tests which involve managerial equity incentives. Selection and omitted variable biases can skew point estimates in either direction, limiting the inference of OLS estimates. Second, these studies rely on non-random subsets of all publicly-traded firms that are relatively homogeneous, possibly depressing statistical power in their tests due to insufficient variation in equity compensation.
By addressing these limitations, this study estimates the relationship between bank CEO equity incentives, risk-taking, and profitability. To address data issues, this study compiles a comprehensive dataset of CEO compensation in the banking industry from 1994 to 2008. The resulting dataset contains (i) almost four times more observations and (ii) more than twice the variation in the equity compensation variables than the ExecuComp sample of banks.
Equity incentive proxies associated with the bank CEO’s option portfolio are estimated for more than 743 banks and a total of 4,976 observations; the proxies include the sensitivity of CEO wealth associated with option grants to stock price, or delta, and stock return volatility, or vega. To address endogeneity concerns, the analysis employs a novel set of instrumental variables for option incentive proxies: stock price pressure due to extreme mutual fund flow events, Federal Reserve district-level stock returns, and state income tax rates on financial institutions.
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Do Bank CEO Equity Incentives Induce Excessive Risk-Taking?
