PDF Ebook The Probability of Default, Excessive Risk, and Executive Compensation
The financial crisis of 2008 has many causes, with the role of executive compensation in creating excessive risk taking being frequently cited in the press and by policy makers as a leading candidate. The evidence for or against is scarce. This paper assembles panel data on 113 financial firms from 1995 through 2008, using the financial crisis as a type of ‘stress test’ experiment to determine the relation of equity-based incentives on the probability of default. After estimating these probabilities using a Heston-Nandi specification, we apply a dynamic panel model to estimate statistically the effect of compensation on default risk. The results indicate uniformly that equity-based pay (i.e. restricted stock and options) increases the probability of default, while non-equity pay (i.e. cash bonuses) decreases it. The results are robust across all specifications estimated. The standard model of the positive effects of incentive compensation on risk taking (pay for performance) is not confirmed in the context of excessive risk taking in financial services given the peculiarities of high leverage and regulatory moral hazard.
The causes of the financial crisis are as numerous as suspects in an Agathie Christie mystery. One suspect commonly named is the compensation policies that incentivized top executives of United States financial institutions to take excessive risks precipitating the near collapse of the financial system. The regulatory implications of this claim have been significant. The U.S. federal government introduced compensation guidelines for executive compensation and appointed Kenneth Feinberg as “Special Master of Compensation” to ensure that companies receiving TARP funding acted in accordance with government compensation guidelines. This appointment was part of a call for reforms in the financial service industry not just for TARP recipients but for all industry participants. The compensation guidelines set out by the US Treasury Secretary, Timothy Geithner, seek to “align the interest of shareholders and reinforce the stability of the financial system.” (Treasury Dept, 7/10/2009) Federal Reserve Chairman Ben Bernanke described the fed’s efforts to develop rules that will “Ask or tell banks to structure their compensation, not just at the top but down much further, in a way that is consistent with safety and soundness – which means that payments, bonuses and so on should be tied to performance and should not induce excessive risk.” (WSJ, 5/13/2009).
The academic evidence that speaks to this claim of excessive risk is surprisingly sparse. The treatment of compensation and risk has conventionally assumed that effort bythe agent increases in risk, even if inefficiently in a “second best” world as the principal is conventionally assumed to be risk-neutral, while the agent is risk averse. While relevant to our study, this approach is misleading in the context of extreme events such as a financial crisis insofar that the risk neutrality assumption for the principal ignores the system and economy wide cost of financial distress and the probability of default. Correspondingly we focus on excessive risk as increases in default probabilities.
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PDF Ebook The Probability of Default, Excessive Risk, and Executive Compensation
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