Executive Short-Term Incentive, Risk-Taking and Leverage-Neutral Incentive Scheme
Annals of Financial Economics (AFE), Vol. 7, Issue 1, pp. 1250003-1:45, 2012
64 Pages Posted: 22 Jul 2009 Last revised: 29 Sep 2013
Date Written: January 7, 2011
In 23 out of 26 U.S. industries, the annual CEO bonus is larger than the annual salary, suggesting that the bonus strongly affects the CEO’s decisions. As the high leverage of financial institutions is often blamed for the 2008 financial crises, in this study we focus on leveragre as a factor determining risk, particularly in finnacial institutuions. The typical bonus scheme is not a leverage-neutral bonus scheme (LNBS), as the agent’s optimal policy is to employ a corner solution: either zero or exteremely high leverage. Thus, consistent with Ross (2004), the bonus scheme does not neccesarily induce the agent to take greater risks. However, although more leverage is not preffered by allpreferences, in most cases it is preffered. Thus, we suggest a combination of incentive parameters, which makes the agent indifferent to leverage, thereby preventing conflict beween the agent and the principal (stockholders).
Keywords: Executive compensation, leverage-neutral bonus scheme, bonus cap, risk-taking
JEL Classification: D2, D3, G38, J33
Suggested Citation: Suggested Citation