Debt in the Bank: CEOs, Compensation, and Risk

The Dodd-Frank Act was enacted in 2010 to curb excessive risk-taking behavior at U.S. financial institutions. One of the bill’s goals was to limit high risk-behavior stemming from incentive-based compensation packages designed for CEOs. This rationale invites the question of whether there is a significant relationship between executive compensation and excessive risk-taking at banks. Moreover, can regulation of executive compensation actually control risk-taking behavior at banks? Rosalind L. Bennett, Levent Güntay, and Haluk Unal shed light on these questions in their working paper, “Inside Debt, Bank Default Risk and Performance during the Crisis.”

Much of the current research on CEO compensation packages focuses on inside equity, which is firm equity and stock options. Instead, Bennett, Güntay, and Unal evaluate whether bank holding companies (BHCs) that compensate their CEOs with higher inside debt (deferred compensation and pension benefits) relative to inside equity had a lower risk of default and better performance during the 2008 financial crisis. The authors call the relationship between inside debt and inside equity the “inside debt ratio.” The authors also explore whether the inside debt ratio is a more powerful tool for analyzing default risk and performance in BHCs, as compared to measures based on inside equity.

Regardless of a whether a CEO is compensated by inside debt or inside equity, a CEO’s actions are always incentivized. In theory, wealth in the form of inside equity aligns the interests of the CEO with those of the shareholders, rewarding risk-taking behavior that improves short-term stock performance. On the contrary, when compensation is tied to inside debt, the CEOs’ concerns should lie with the long-term solvency of the firm, thereby reducing inappropriate risk behavior.

Using multivariate analysis, the authors found that CEOs who had a higher inside debt ratio in 2006 exposed their firms to less default risk after the financial crisis in 2008. Additionally, they found that the inside debt ratio is a better indicator for a BHC’s default risk, compared to measures using inside equity. They contend that CEOs who are compensated with a higher inside debt have better incentives to consider both the interests of shareholders and debt holders. In other words, this alignment in incentives should lower the default probability in a crisis environment.

The authors’ findings support the premise that inside debt ratio plays an important role in determining whether a CEO at a financial institution is likely to engage in excessive risk-taking. In the sample of the 371 BHCs studied, the average level of inside debt compensation for CEOs was $3 million, and the average inside equity was $41 million. This indicates that a compensation structure existed that provided greater incentives for CEOs to favor the interests of shareholders over the long-term financial health of the firm itself.

Overall, this study provides strong evidence that there is a correlation between the form of compensation and risk-taking behavior at firms. In addition, the study also suggests that if executive compensation practices were better-regulated, risky behavior may be minimized. The authors propose that stakeholders of financial institutions develop strategies to better identify those compensation structures that may incentivize harmful risk-taking behavior by CEOs and their financial institutions.

Feature Photo: cc/ (401(K) 2012)