Leverage, CEO Risk-Taking Incentives, and Bank Failure During the 2007-2010 Financial Crisis

Patricia Boyallian is Assistant Professor at Lancaster University Management School; and Pablo Ruiz-Verdu is Associate Professor of Management at the Universidad Carlos III de Madrid. This post is based on their article, forthcoming in the Review of Finance. Related research from the Program on Corporate Governance includes Regulating Bankers’ Pay by Lucian Bebchuk and Holger Spamann (discussed on the Forum here); The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008 by Lucian Bebchuk, Alma Cohen, and Holger Spamann (discussed on the Forum here); and How to Fix Bankers’ Pay by Lucian Bebchuk (discussed on the Forum here).

The view that bankers’ compensation created the incentives that led to the latest financial crisis has prompted numerous proposals to regulate pay at financial institutions. [1] However, despite the attention devoted to executive pay by regulators, extant research provides mixed support for the hypothesis that CEO compensation in the run-up to the crisis influenced bank risk taking. Thus, although some authors find a positive relation between CEO risk-taking incentives and bank risk or policy choices, others find no such relation. Notably, Fahlenbrach and Stulz (2011) [2] find no significant relation between the most commonly used measure of the risk-taking incentives generated by executive compensation (vega) and bank performance during the crisis. [3]

In our article, Leverage, CEO Risk—Taking Incentives, and Bank Failure during the 2007–2010 Financial Crisis, we argue that standard measures of the risk-taking incentives generated by executive compensation, which focus on the incentives generated by stock options, do not capture a potentially large component of bank CEOs’ incentives to take on risk, namely the incentives generated by their stock holdings. Indeed, because of limited liability, equity holders have the incentive to shift risk to debtholders and other claim holders, and this incentive is especially strong for the equity holders of highly levered firms, such as large U.S. financial institutions. Therefore, we test the hypothesis that a greater sensitivity of a CEO’s wealth to his firm’s stock price (known as delta), by aligning the CEO’s incentives with those of shareholders, will increase the CEO’s risk-taking incentives in highly levered banks but not, or to a lesser degree, in banks with low leverage.

To investigate the relation between CEO risk-taking incentives prior to the financial crisis and risk, we use failure during the crisis period (2007-2010) as the measure of firm risk. We measure risk ex post to capture the tail risk that is unlikely to be captured by standard risk measures if they are computed prior to the crisis. To account for the possibility that regulators may intervene to prevent the default of some banks by brokering their acquisition by healthier ones, we use an encompassing definition of bank failure that includes not only closures but also acquisitions of distressed banks with the intervention of supervisors. As a case in point, on March 16, 2008, Bear Stearns agreed to be acquired by JPMorgan for $2 per share, which represented a more than 90% discount relative to the previous closing price (although the acquisition price was subsequently raised to $10 per share). The Federal Reserve brokered the deal and provided financial assistance by funding the purchase of Bear Stearns’ troubled assets. Although Bear Stearns did not default, our measure considers it a failed financial institution.

We estimate the relation between risk-taking incentives measured in year 2006 and bank failure in the period 2007-2010 for a sample of large US financial institutions. Our results show that, whereas a higher delta is associated with a significantly higher (both statistically and economically) probability of failure in highly levered firms, it does not have a significant relation with the probability of failure in less levered firms. We find no significant relation between bank failure and the sensitivity of the value of CEOs’ stock option portfolios to the volatility of their firms’ stock (vega). We also find little or no relation between different corporate governance measures and bank risk. If anything, greater ownership by institutional blockholders seems to be associated with a higher risk of failure. The results are robust to the use of different sets of control variables (such as measures of CEO’s inside debt, termination payments, CEO age and tenure, or bank complexity), specifications, or subsamples. They also hold, albeit in weaker form, if we measure bank risk by means of distance to default, the corresponding expected default frequency, buy-and-hold returns, market beta, or stock price volatility, measured during the financial crisis. Therefore, our evidence is consistent with the hypothesis that the risk-taking incentives generated by CEO compensation influenced firm risk among financial firms, although we also discuss alternative non-causal explanations for our findings.

Our article makes several contributions to the debate about the relation between executive compensation and risk in financial firms. First, we show that the risk-taking incentives generated by CEOs’ stock and option compensation are associated with risk in financial firms, in contrast with some of the results in previous literature. Second, we provide evidence that the relevant source of risk-taking incentives for the CEOs of large financial firms prior to the crisis was their exposure to their firms’ stock returns. We find no evidence that the incentives to increase stock return volatility that may have been created by CEOs’ stock option holdings were associated with a higher probability of failure. Therefore, our results suggest that the stronger risk-taking incentives of the CEOs of some financial firms were not the result of a misalignment between CEOs’ and shareholders’ incentives in those firms. Instead, a better alignment between CEOs’ and shareholder incentives seems to have encouraged CEOs to shift risk to debtholders and depositors. Our results also have the implication that banking supervisors should consider compensation arrangements in relation to leverage when they evaluate the risk-taking incentives created by executive compensation. Finally, by establishing a link between CEO compensation and risk in financial firms, our results suggest that regulating CEO compensation in financial firms may have an impact on risk, but that simply replacing stock options with stock may not reduce risk.

The complete article is available here.


1Section 956 of the 2010 Dodd-Frank Act requires that the banking agencies regulate compensation arrangements at large financial institutions to discourage inappropriate risk taking, and, in 2011 and 2016, the agencies proposed rules to regulate pay in financial institutions. Outside of the United States, regulatory action has been intense as well. The European Union approved directives CRD III (in 2010) and CRD IV (in 2013), which contain provisions that regulate compensation at financial institutions, and the Committee of European Banking Supervisors (in 2010) and the European Banking Authority (in 2015) issued guidelines on sound remuneration policies. In the United Kingdom, the Financial Services Authority issued in 2009, and amended in 2010, the so-called Remuneration Code, and the Prudential Regulation Authority and the Financial Conduct Authority issued remuneration rules for financial firms in 2015. At the multinational level, the Financial Stability Forum issued the Principles for Sound Compensation Practices in 2009.(go back)

2Fahlenbrach, R. and Stulz, R. (2011) Bank CEO incentives and the credit crisis, Journal of Financial Economics 99, 11–26.(go back)

3The usual definition of the vega of a CEO’s portfolio of stock options is the dollar change in the value of the portfolio associated with a 0.01 increase in the volatility of the firm’s stock returns.(go back)


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