CEO Severance Pay and Risk Taking in the Banking Industry

Abstract

We examine 354 CEO severance contracts relating to 138 S&P 500 firms from the banking sector during the period 2002-2008 to study the impact of severance agreements on risk-taking in the banking sector. We find that the existence of severance contracts induces risk-taking as measured by total and idiosyncratic return volatility and encourages excessive risk-taking as measured by the default likelihood, after controlling for CEO pay-performance sensitivity (delta) and the sensitivity of CEO compensation to stock return volatility (vega). We also report a positive association between changes in firm-level risk (and the default likelihood) and the existence of a severance contract. Third, we show a significant positive contemporaneous and causal relation between the amount of severance pay and conventional and excessive risk-taking after controlling for the incentive effects of cash and equity-based compensation. Finally, our results are robust when we control for self-selection bias and endogeneity issues. Our results support the risk-shifting argument and suggest that severance agreements induced excessive risk-taking in the banking sector and provide support for recently enacted reforms on severance pay.

Keywords: Managerial compensation, Severance pay, Risk Taking

JEL Classification: G32, G34