Managerial Risk-Taking Incentives and the Systemic Risk of Financial Institutions
55 Pages Posted: 17 Aug 2017 Last revised: 5 Dec 2018
Date Written: October 22, 2018
This paper examines whether the systemic risk of financial institutions is associated with the risk-taking incentives generated by executive compensation. We measure managerial risk-taking incentives with the sensitivities of chief executive officer (CEO) and chief financial officer (CFO) compensation to changes in stock prices (pay-performance sensitivity) and stock return volatility (pay-risk sensitivity). Using data on large U.S. financial institutions over the period 2005–2010, we document a negative association between systemic risk and the sensitivities of CEO and CFO compensation to stock return volatility. However, our results also demonstrate that financial institutions with greater managerial risk-taking incentives were associated with significantly higher levels of systemic risk during the peak of the financial crisis in 2008. We further document that the relation between pay-performance sensitivity and systemic risk is essentially nonexistent. Overall, our empirical findings indicate that the association between managerial risk-taking incentives and banks’ systemic risk is ambiguous and is not stable over time.
Keywords: executive compensation, delta, vega, risk-taking incentives, systemic risk, bank risk-taking, financial crisis
JEL Classification: G01, G20, G21, G30, G32, G34
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