The Probability of Default, Excessive Risk, and Executive Compensation: A Study of Financial Services Firms from 1995 to 2008
Columbia University - Columbia Business School
Columbia Business School - Management
affiliation not provided to SSRN
February 1, 2010
Columbia Business School Research Paper
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 117 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 default 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.
Number of Pages in PDF File: 69
Keywords: financial crisis, executive compensation, equity-based incentivesworking papers series
Date posted: August 23, 2011 ; Last revised: September 19, 2011
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