Yesterday's Heroes: Compensation and Risk at Financial Firms
Dartmouth College - Tuck School of Business
Harrison G. Hong
Princeton University - Department of Economics; National Bureau of Economic Research (NBER)
Jose A. Scheinkman
Columbia University; Princeton University - Department of Economics; National Bureau of Economic Research (NBER)
September 1, 2013
AFA 2011 Denver Meetings Paper
ECGI - Finance Working Paper No. 285/2010
Many believe that compensation, misaligned from shareholder value due to managerial entrenchment, caused some financial firms to take creative risks before the Financial Crisis of 2008. We argue instead that pay and risk can be correlated even in a classical principal-agent setting where entrenchment is absent and firm risk is exogenous. To incentivize managers, shareholders give them ownership stakes. For the same stake, risk-averse managers at riskier firms face greater wealth uncertainty since their stock prices are more volatile. They then need to receive greater total pay to compensate them for bearing extra risk. Using lagged stock return volatility, even back to when a firm first goes public, as a measure of exogenous firm risk, we confirm our conjecture that firm risk leads to pay. We also find that institutional investors, who are most likely to be able to influence managers and understand company risks, were more likely to hold riskier finance firms.
Number of Pages in PDF File: 47
Keywords: financial crisis, executive compensation
JEL Classification: G2, G34Accepted Paper Series
Date posted: November 11, 2009 ; Last revised: October 29, 2013
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