Managerial Compensation, Regulation and Risk in Banks: Theory and Evidence from the Financial Crisis

52 Pages Posted: 27 Jul 2014 Last revised: 21 Oct 2014

See all articles by Vittoria Cerasi

Vittoria Cerasi

Bicocca University - Department of Economics, Management & Statistics (DEMS)

Tommaso Oliviero

University of Naples Federico II - CSEF - Center for Studies in Economics and Finance; University of Naples Federico II - Department of Economic and Statistical Sciences; Università degli Studi di Milano-Bicocca - Center for European Studies (CefES)

Date Written: July 25, 2014

Abstract

This paper analyzes the relation between CEOs monetary incentives, financial regulation and risk in banks. We present a model where banks lend to opaque entrepreneurial projects to be monitored by managers; managers are remunerated according to a pay-for-performance scheme and their effort is unobservable to depositors and shareholders. Within a prudential regulatory framework that defines a capital requirement and a deposit insurance, we study the effect of increasing the variable component of managerial compensation on risk taking. We then test empirically how monetary incentives provided to CEOs in 2006 affected banks' stock price and volatility during the 2007-2008 financial crisis on a sample of large banks around the World. The cross-country dimension of our sample allows us to study the interaction between CEO incentives and financial regulation. The empirical analysis suggests that the sensitivity of CEOs equity portfolios to stock prices and volatility has been indeed related to worse performance in countries with explicit deposit insurance and weaker monitoring by shareholders. This evidence is coherent with the main prediction of the model, that is, the variable part of the managerial compensation, combined with weak insiders' monitoring, exacerbates the risk-shifting attitude by managers.

Keywords: managerial compensation, risk taking, financial regulation, monitoring

JEL Classification: G21; G38

Suggested Citation

Cerasi, Vittoria and Oliviero, Tommaso, Managerial Compensation, Regulation and Risk in Banks: Theory and Evidence from the Financial Crisis (July 25, 2014). University of Milan Bicocca Department of Economics, Management and Statistics Working Paper No. 279. Available at SSRN: https://ssrn.com/abstract=2472135 or http://dx.doi.org/10.2139/ssrn.2472135

Vittoria Cerasi (Contact Author)

Bicocca University - Department of Economics, Management & Statistics (DEMS) ( email )

Piazza dell'Ateneo Nuovo, 1
Milan, 20126
Italy
+39-02-64485821 (Phone)
+39-02-64485878 (Fax)

Tommaso Oliviero

University of Naples Federico II - CSEF - Center for Studies in Economics and Finance ( email )

Via Cintia
Complesso Monte S. Angelo
Naples, Naples 80126
Italy

University of Naples Federico II - Department of Economic and Statistical Sciences ( email )

Via Cintia 26
Napoli
Italy

Università degli Studi di Milano-Bicocca - Center for European Studies (CefES) ( email )

U6 Building
Viale Piero e Alberto Pirelli, 22
Milano, 20126
Italy

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