Yesterday's Heroes: Compensation and Creative Risk-Taking

Abstract:     
Many believe that outsized pay due to entrenchment led to creative risk-taking by managers at some finance firms. We point out, using a neglected insight from neoclassical contracting, that pay and firm risk can be correlated even absent entrenchment and in a setting where firm risk is exogenous. If the sensitivity of pay to stock price, which is measured by insider ownership, does not vary with stock price volatility, which we verify is the case for finance firms, then total compensation has to increase with firm risk to satisfy a risk-averse agent’s individual participation constraint. Indeed, we find a correlation between total annual executive compensation, controlling for firm size, and the firm’s stock market beta, return volatility, and exposure to the ABX sub-prime index. We find that pay increases with lagged firm risk measured in its public offering year but is uncorrelated with proxies for entrenchment.

Number of Pages in PDF File: 48

Keywords: financial crisis, executive compensation

JEL Classification: G2, G34

Accepted Paper Series