The Probability of Default, Excessive Risk, and Executive Compensation: A Study of Financial Services Firms from 1995 to 2008
69 Pages Posted: 23 Aug 2011 Last revised: 19 Sep 2011
Date Written: February 1, 2010
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.
Keywords: financial crisis, executive compensation, equity-based incentives
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