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

See all articles by Sudhakar V. Balachandran

Sudhakar V. Balachandran

University of Illinois at Chicago

Bruce Kogut

Columbia University - Sociology/Columbia Business School

Hitesh Harnal

affiliation not provided to SSRN

Date Written: February 1, 2010

Abstract

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

Suggested Citation

Balachandran, Sudhakar V. and Kogut, Bruce and Harnal, Hitesh, The Probability of Default, Excessive Risk, and Executive Compensation: A Study of Financial Services Firms from 1995 to 2008 (February 1, 2010). Columbia Business School Research Paper, Available at SSRN: https://ssrn.com/abstract=1914542 or http://dx.doi.org/10.2139/ssrn.1914542

Sudhakar V. Balachandran

University of Illinois at Chicago ( email )

1200 W Harrison St
Chicago, IL 60607
United States

Bruce Kogut (Contact Author)

Columbia University - Sociology/Columbia Business School ( email )

3022 Broadway
New York, NY MA 10027
United States

Hitesh Harnal

affiliation not provided to SSRN

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