CEO Bonus Compensation and Bank Default Risk: Evidence from the U.S. and Europe

Abstract

We investigate the link between the incentive mechanisms embedded in CEO cash bonuses and the riskiness of banks. For a sample of U.S. and European banks, we employ the Merton distance to default model to show that increases in CEO cash bonuses lower the default risk of a bank. However, we find no evidence of cash bonuses exerting a risk-reducing effect when banks are financially distressed or when banks operate under weak bank regulatory regimes. Our results link bonus compensation in banking to financial stability and caution that attempts to regulate bonus pay need to tailor CEO incentives to the riskiness of banks and to regulatory regimes.

Keywords: banks, default risk, executive compensation

JEL Classification: G21, G33, J33