Why Do Banks Fail Together? Evidence From Executive Compensation

Abstract

Recent bank failures have elicited extensive interest about the causes, focusing on incompetence of bank executives, policymakers, bank regulators and supervisors and even uninsured depositors. Yet, before we can prescribe solutions to bank failures, we need to identify the correct causes of the underlying problems. We argue that the problem is not so much with incompetence of executives, depositors, or regulators per se, but rather with managerial incentives.

We provide both a conceptual basis as well as empirical evidence to show that bank executives have incentives to increase systemic risks in order to maximize the benefits of bank bailouts. Consequently, looking at the overall bank risks, although useful, misses an important part of the picture of moral hazard problem. We argue that while bank executives are incentivized to increase systemic risk for the best interest of shareholders, these incentives also exacerbate the problem of financial stability.

Thus, any effort to alleviate the moral hazard problem requires an understanding and control of the incentives of bank managers. The mismatch between the cost of the deposit insurance premiums and the benefits of the bailout create an arbitrage opportunity for banks to maximize the net benefits of deposit insurance. We provide recommendations to counteract the distorting effects of bank incentive programs to take on excessive levels of systemic risk.

Keywords: Bank moral hazard; Systemic risk; Executive compensation; Relative performance evaluation

JEL Classification: G21; G33; G34; K22