Journal of Economics and Business

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1 Journal of Economics and Business 63 (2011) Contents lists available at ScienceDirect Journal of Economics and Business CEO incentives and bank risk James Cash Acrey, William R. McCumber, Thu Hien T. Nguyen Department of Finance, Sam M. Walton College of Business, University of Arkansas, Fayetteville, AR 72701, United States a r t i c l e i n f o Article history: Received 2 February 2010 Received in revised form 30 August 2010 Accepted 20 September 2010 JEL classification: G01 G21 G32 J33 Keywords: CEO compensation Bank risk Bank regulation Bank failure Bank EDF a b s t r a c t We investigate the relationship between CEO compensation and bank default risk predictors to determine if short-term incentives can explain recent excesses in bank risk. We investigate early warning off-site surveillance parameters and expected default frequency (EDF) as well as crisis-related risky bank activities. We find only modest evidence that CEO compensation structures promote significant firm-specific heterogeneity in bank risk measures or risky activities. Compensation elements commonly thought to be the riskiest components, unvested options and bonuses, are either insignificant or negatively correlated with common risk variables, and only positively significant in predicting the level of trading assets and securitization income Elsevier Inc. All rights reserved. 1. Introduction and motivation This economic crisis began as a financial crisis, when banks and financial institutions took huge, reckless risks in pursuit of quick profits and massive bonuses. When the dust settled, and this Special consideration should be given to this paper due to the timeliness of bank reform legislation and the growing popular outcry about bank CEO composition. The data was collected from ExecuComp and Y9-C reports. The paper offers confirmation of the Fahlenbrach and Stulz (2009) finding of incentive alignment between shareholders and bank CEOs, uses estimates of bank default probabilities common to industry, and expands the literature on CEO compensation, bank CEO compensation, bank specialness, bank failure, systemic banking risk, EDF, banking regulation, and agency theory. Corresponding author. Tel.: addresses: jacrey@walton.uark.edu (J.C. Acrey), WMcCumber@walton.uark.edu (W.R. McCumber), TNguyen@walton.uark.edu (T.H.T. Nguyen) /$ see front matter 2010 Elsevier Inc. All rights reserved. doi: /j.jeconbus

2 J.C. Acrey et al. / Journal of Economics and Business 63 (2011) binge of irresponsibility was over, several of the world s oldest and largest financial institutions had collapsed, or were on the verge of doing so (President Barack Obama, January 21, 2010). Bank executives faced widespread criticism in the wake of the financial crisis for privatizing gains and socializing losses 1. New York Attorney General Andrew Cuomo blasted the Heads I Win, Tails You Lose culture of bank bonuses, claiming banks abuse the government s safety net to capture upside gains without suffering downside losses because rapid compensation inflation during good times remains high during periods of poor bank performance (Cuomo, 2009). Two dozen bank CEOs collectively gained over $90 million in stock options during the crisis, further fueling public outrage (Gomstyn, 2009). The FDIC recently approved a policy to set deposit insurance premiums based, in part, on compensation practice. At the time of this writing, Congress and the Obama administration are attempting to force banks to dramatically change executive compensation. H.R. bill 3269 aims to align compensation with long-term bank performance to reduce any preferences for short-term profits at the expense of long-term bank solvency. The bill directs the Comptroller General of the United States to undertake a rigorous study to determine whether there is a correlation between compensation structures and excessive risk taking that contributed to the crisis. We motivate this research with the same objective. Arguments for regulating compensation to curtail bank risk-taking critically assume that CEO compensation must drive bank risk. The contribution is by no means an established empirical fact. Fahlenbrach and Stulz (2009) find no substantial evidence of agency problems during the financial crisis that can be linked to bank CEO compensation. Gorton (2009) details complications in regulating pay in a banking system increasingly dominated by shadow banking and pressured by a fiercely competitive labor market. Levine (2004) advocates increased transparency to relieve regulators and allow market discipline to punish overly aggressive risk-taking. This market-based narrative lends support to those who blame regulators and government interference for the crisis. We study the explanatory power of CEO compensation on common bank default risk measures and, ex post, crisis-sensitive risky bank activities. We find only modest evidence that structural differences in bank CEO compensation, or any specific elements of CEO compensation, predict firm-specific heterogeneity in bank risk-taking activities. Our evidence lends support to the Fahlenbrach and Stulz (2009) conclusion that CEO compensation was not a cause of the financial crisis and does not explain bank risk. The remainder of this paper proceeds as follows: Section 2 reviews the relevant literature. Section 3 develops our testable hypotheses. Section 4 describes our sample and defines our variables. Section 5 details our methodology. Section 6 reports our results. Section 7 concludes and offers avenues for future research. 2. Literature review Murphy (1999) claims that compensation plans should align the interests of risk-averse executives with those of shareholders. Through a base salary, an annual bonus tied to accounting performance, stock options, and long-term incentive plans (including restricted stock plans and multi-year accounting-based performance plans), shareholders intend to compensate executives for their overinvestment of human capital in a single firm and their undiversified personal wealth portfolios. In studying the financial crisis, Fahlenbrach and Stulz (2009) conclude that high levels of insider ownership (the classic correction to the principal/agent incentive alignment problem) did not lead the banks to take excessive risk. Bank CEOs suffered large losses during the crisis, indicating that while executives maintained well-aligned equity ownership stakes they may have misunderstood the accretion of risk occurring within the banking system. In contrast, Bebchuk and Spamann (2009) argue that the principal agent conflict between bank owners and managers has been effectively externalized to the taxpayers, and that compensation structures strongly determine the risk preferences of managers. Perhaps bank CEOs directed their firms into 1 Joseph Stiglitz, in various interviews with regard to his book, Freefall: America, Free Markets and the Sinking of the World Economy, 2010.

3 458 J.C. Acrey et al. / Journal of Economics and Business 63 (2011) projects and business that shareholders valued and for which the CEOs were justly compensated. If so, managerial interests were properly aligned with the risk appetites of their common shareholders. One can argue that the truly toxic tranche of large bank equity ownership is implicitly held by the taxpayers in the event of a systemic banking collapse. Jeitschko and Jeung (2005) model the moral hazard of deposit insurance as an agency problem that increases managerial risk-taking incentives. Houston and James (1995) report that bank CEO compensation policies promote risk-taking, as the cash-to-equity compensation ratio in banking and financial services dominates cash compensation in other industries. As bank risk increases, judged by an increasing proportion of non-interest income sources, the proportion of equity-based CEO compensation also increases (Brewer, Hunter & Jackson, 2004). Bryan, Hwang, and Lilien (2000) claim restricted stock fails to induce risk-averse CEOs to accept riskier projects that should increase value. Clementi and Cooley (2009) find highly skewed compensation measures, where many CEOs lose money due to the equity-based portion of their wealth, reinforcing the notion that performance incentives have strengthened over time. Douglas (2006) shows that value-maximizing compensation contracts induce bank managers to pursue riskier profits from opaque investments with high levels of information asymmetry. During a financial crisis, the opacity and complexity of assets become a liability when a firm needs to raise capital. As heated opinions motivate new bank regulation, market discipline advocates fault existing crisisinducing regulatory burdens. Palia (2000) warns that regulated industries attract CEO candidates with lower education levels than deregulated industries. Thompson and Yan (1997) argue that Federal Deposit Insurance Corporation Improvement Act regulation diminishes the effectiveness of private executive compensation contracts. Perhaps the most closely related literature to our study is a recent working paper by Cheng, Hong, and Scheinkman (2009) examining total executive compensation (combining cash and equity pay) as it impacts financial firm risk. They employ Murphy s (2000) theory of irrelevance in the incentive effects of cash and equity compensation. Our research compliments and extends this study by separating the components of bank CEO compensation. We incorporate a practitioner-oriented default risk measure, a list of variables based on risky activities specific to the banking industry, and a view of risk which explicitly isolates the impact of short-term CEO incentives relative to the crisis. Our work utilizes and expands threads on CEO compensation, bank risk and default risk, agency theory, and banking regulation. 3. Hypothesis development Does bank compensation increase bank risk and fuel a short-term bias? Did CEO compensation drive the risky behavior of banks leading to the financial crisis? We test the hypothesis that CEO compensation motivates bank risk by seeking a significant correlation between bank risk and compensation structures. We rely on a variety of risk measures used in credit analysis by regulators, banks and industry analysts, and a subset of risky activities specifically related to the financial crisis. We decompose CEO compensation into short-term and long-term components, and connect these to future risky activities undertaken by the bank. Our null hypothesis is that bank CEO compensation has no significantly positive correlation to risky bank activities. We focus on publicly traded bank holding companies (BHCs) in order to have meaningful comparisons of accounting data between firms; BHCs must file quarterly reports with the Federal Reserve that include accounting and holdings data, including supporting schedules and off balance-sheet items. We expect bonuses to positively correlate with risk due to their explicit short-term performance focus. Salary is expected to be negatively correlated with risk, as undue risk jeopardizes a CEO s salary and continued employment. In optimal contracting theory, fixed salaries satisfy the reservation wage, and the bonuses satisfy the incentive compatibility constraint. As both cash components are realized within the year, the comprehensive cash compensation package is expected to correlate positively with a short-term focus and risk-taking, with bonuses dominating salary in influence. If CEOs did indeed take large risks in pursuit of big bonuses, bonuses should be related positively and strongly to short-term performance and risk-taking.

4 J.C. Acrey et al. / Journal of Economics and Business 63 (2011) Our expectations of long-term incentives are more nuanced. Agency theory predicts that bank risk should be an increasing function of equity holdings, if managers must be induced to take more risk than they would without the incentive alignment offered by ownership (wealth effects from large equity holdings, discussed below, may reduce a CEO s risk appetite). Equity incentives are not meant to promote excessive risk that jeopardizes the firm, though banks may be less bound by this constraint if they exploit the safety net of insured deposits, or reasonably expect that the government will rescue systemically important firms. CEO wealth is largely undiversified in own-firm equity. Vested equity stakes should increase risk aversion via wealth protection effects, while unvested shares and options should raise risk appetite through wealth accumulation effects (Agrawal & Mandelker, 1987). A CEO s ability to sell vested shares may attenuate this bias, but the market signaling effect of large insider sales should dampen levels of CEO equity sales. We expect a negative impact on short-term risk due to vested securities, and a positive impact from unvested shares and options. 4. Data definitions and summary statistics 4.1. Sample Our study requires detailed compensation data for the largest banks in the U.S., those most likely to pose systemic risk. We use Compustat s ExecuComp database and searched for CEO compensation data on all firms with SIC codes , 6080, 6081, 6082, 6090, 6199, 6712, and FR Y-9C reports from the Chicago Federal Reserve provided bank accounting data. For the primary hypotheses we focus on years We use 2-year lags of compensation variables to control for endogeneity between contemporaneous risk and compensation. Our sample size for 2008 (with 2006 compensation variables) is Independent variables CEO compensation and control variables CEO compensation variables are scaled by total compensation, which is defined as salary, bonus, all other (perks), total value of restricted stock granted, total value of options granted, and longterm incentive payouts. Option values use the Black Scholes Merton methodology as per ExecuComp. Variables are grouped by short-erm and long-term incentive structure; bonuses are incentives for meeting short- to intermediate-term accounting measures goals, whereas vested shares should align manager and shareholder incentives over the long term. Fig. 1 lists the variables used in our analysis and their expected effects on firm risk. Short-term compensation includes cash compensation components. We include an interactive term, bonus interactive, which is the product of annual salary and bonus figures. We do this to capture any marginal effects of high cash compensation. For example, salary or bonus may not be significant predictors of bank risk, but the combination (high bonuses in the presence of high salary) may be significant. Long-term compensation is divided into vested and unvested shares and options. Table 1 reports summary statistics on the independent variables used in the study. Although all of the firms in the study are large banking firms, there is considerable variation in how CEOs are compensated. On one end of the spectrum, salary comprises nearly all of the compensation granted to the CEO, while on the other end bonuses comprise almost 63% of total compensation. Interestingly, relatively few banks award their CEOs bonuses at all; at the 50th percentile no bonuses are paid, and at the 75th percentile, only 5% of the total compensation is in the form of bonuses. Vested long-term cumulative compensation (vested shares and exercisable options) dwarfs the unvested wealth of bank CEOs. At the means, vested shares are 13 times the value of unvested shares, and exercisable options are worth 10 times the amount of un-exercisable options. This could significantly impact incentive schemas, as CEOs may sell vested shares and exercisable options, reducing the alignment between executive and shareholder interests. Since executives must report sales and exercised options, sending a negative signal to the market, vested equity may actually decrease risk taking as executives keep their shares and attempt to protect their wealth.

5 460 J.C. Acrey et al. / Journal of Economics and Business 63 (2011) Variable Description Expected effect on short term risk level salary_tc bonus_tc salary_bonus_tc bonus_interactive Short term salary as a percentage of total annual compensation - bonus as a percentage of total annual compensation + cash compensation as a percentage of total annual compensation +/- interaction term combining effects of bonuses and salary +/- shr_flow_tc opt_flow_tc Long term, current value of shares granted in current year as a percentage of total annual compensation value of options granted in current year as a percentage of total annual compensation - - vested_shr_tc unvested_shr_tc vested_opt_tc unvested_op_tc pct_shr_own total_shr_value Long term, cumulative value of vested shares as a percentage of total annual compensation - value of unvested shares as a percentage of total annual compensation value of vested options as a percentage of total annual compensation - value of unvested options as a percentage of total annual compensation percentage of total outstanding shares of the firm owned by the CEO, excluding options - total value of all shares owned, excluding options, as a percentage of total annual compensation Control variables age age of the executive + tenure number of years as CEO + 1 if the firm has a new CEO during the year, 0 otherwise + ln_assets natural log of total firm assets +/- ceo_change tobin_q Tobin's Q, a measure of market power as represented by market value vs. book value of assets +/- Fig. 1. Variable descriptions and expected relations to bank risk Dependent variables: SEER bank risk determinants We first select dependent variables used in off-site bank surveillance. These variables are taken from Y9-C reports and have been proven to be effective determinants of the probability that a bank will fail within two years (Cole & Gunther, 1995). These risk measures appear in the Federal Reserve s System to Estimate Examination Ratings (SEER) early warning model used for off-site surveillance (Gilbert, Meyer, & Vaughan, 2000). We scale these variables by total assets, and group according

6 J.C. Acrey et al. / Journal of Economics and Business 63 (2011) Table 1 Summary descriptions of independent variables. Variable N Mean Standard deviation 25th percentile Median 75th percentile Max Executive compensation Salary tc Bonus tc Bonus interactive Shr flow tc Opt flow tc Vested shr tc Unvested shr tc Vested opt tc Unvested opt tc Control variables Age Tenure CEO change ln assets Tobin q Executive compensation data are from Compustat ExecuComp. All compensation variables are normalized by dividing by total compensation (TDC1), defined as salary, bonus, all other, total value of restricted stock grants, total value of option grants, and long term incentive payouts in Bonus interactive is the product of salary and bonus divided by total compensation. Shr flow and opt flow are the shares and options values, respectively, awarded during the year. Vested/unvested shares/options are the fair values of cumulative past awards of shares and options, either vested or unvested, as of Option portfolio values are computed using the modified Black Scholes Merton methodology, as per ExecuComp. CEO change is a binary variable taking the value of 1 if the firm has a new CEO during the fiscal year and 0 otherwise. ln assets is the natural log of firm assets. Tobin q is Tobin s Q, a measure of market power wherein market valuation is compared to book value; a number greater than one indicates the market value of the firm is greater than the replacement cost of its assets. to their predicted impact on bank risk. The first group represents predicted increases in risk, and includes: DelqLoan30d are a bank s interest-accruing loans which are between 30 and 89 days past due; DelqLoan90+d are a bank s interest-accruing loans which are at least 90 or more days past due; NonAccruLoan refers to the bank s delinquent loans which are not accruing interest; ForclRealEst is the book value of foreclosed real estate; JumboCDs is the value of domestic certificates of deposit, $100,000 or greater in value. The remaining SEER-based variables are expected to have a negative relation to risk. These variables include: TangibleCapital is the bank s equity, less goodwill; OpIncome is net operating income before extraordinary items, less the gain (loss) on sale of securities; LoanLossResrv is the allowance for loan and lease loss reserves; InvSecurities is the book value of investment securities; We also use a market-based measure of bank default risk called the expected default frequency (EDF), calculated as in Crosbie and Bohn (2003). A bank s distance to default is calculated as the difference between the market value of assets and the book value of debt, divided by the volatility of the bank s assets. We map the distance measure into a default probability by assuming a normal distribution. EDF increases with asset volatility and decreases with the difference between the market value of assets and the book value of debt. Additionally, we include dependent variables that should be larger for banks that were heavily involved in the risky activities leading up to the financial crisis. We separate the crisis-centric risk variables from the SEER risk framework variables to avoid contaminating our measures and predicting the last crisis. These variables have not traditionally been measures of bank risk but were proven,

7 462 J.C. Acrey et al. / Journal of Economics and Business 63 (2011) ex post, to be relevant risk measures. Several of these reporting items were not mandated by the Fed until recently, while new crisis-sensitive variables such as synthetic and other collateralized debt obligations, retained beneficial interests in securitizations, and loans pending securitization attracted reporting mandates in OtherMBS: Other mortgage backed securities are often called private label MBS because they are often comprised of securitized sub-prime mortgages; these securities are not guaranteed by government backed agencies. For this investigation OtherMBS are securities comprised of first and second liens on one to four family residential properties. %SecuritizInc is net securitization income as a percentage of the bank s net income. Non-interest income could diversify bank income streams and decrease risk; alternatively, it been shown to increase bank risk (Stiroh, 2004). We consider securitization income risky in context, due to the prevalence of subprime mortgage securitization. Trading Assets are assets held at fair value with the intention to sell quickly. These include OtherMBS and other securities such as credit default swaps. We include this as a measure of non-traditional banking activity as compared to typical bank assets, loan portfolios. Recourse includes financial standby letters of credit, performance standby letters of credit, recourse and direct credit substitutes, and other financial assets sold with recourse. Recourse exposes banks to the risk that securities already sold by the bank will underperform and be put back to the bank. We exclude commercial letters of credit, securities lent, or risk participations in bankers acceptances in order to focus on what was most likely to be shared across the sample during the crisis: recourse on MBS-type securities. Table 2 reports summary statistics of risk variables. By the end of 2008, the mean EDF was greater than 25%. At the 75th quartile the default probability rises to almost 50%. Other mortgage-backed Table 2 Summary statistics of dependent variables. Variable N Mean Standard deviation 25th percentile Median 75th percentile Max Bank risk measures DelqLoan30d DelqLoan90d NonAccruLoan ForclRealEst TangibleCapital OpIncome LoanLossResrv InvSecurities JumboCDs EDF Bank risk behaviors OtherMBS Trading Assets %SecuritzInc Recourse Bank risk measure variables are scaled by total value of bank assets as of fiscal year Bank risk behavior variables are scaled by the total value of bank assets as of fiscal year 2006 with the exception of %SecuritizInc which is scaled by net income in DelqLoan30d and DelqLoan90d are the values of delinquent bank loans with a past-due period of or 90+ days, respectively, but still accrue interest and are therefore performing. NonAccruLoan is the value of loans that are no longer accruing interest. ForclRealEst is the book value of foreclosed real estate. TangibleCapital is bank equity less goodwill. OpIncome is net income less extraordinary items and gains (losses) on the sale of securities. LoanLossReserv is the value of reserves against losses in loans and leases. InvSecurities is the value of investment securities. JumboCDs is the value of all domestic certificates of deposit greater than $100,000. EDF is expected default frequency. OtherMBS is the value of other or private label mortgage backed securities not guaranteed by government backed agencies. Trading Assets is the value of all marketable securities held for trading purposes, including mortgage backed securities and credit default swaps. %SecuritzInc is the percentage of income resulting from securitization activity. Recourse is the value of guarantees made by the bank to the buyers of securitized products, and includes financial standby letters of credit, performance standby letters, recourse and direct credit substitutes, and other assets sold with recourse.

8 J.C. Acrey et al. / Journal of Economics and Business 63 (2011) securities comprise a small percentage of total assets, even at the height of their popularity and asset valuations. Almost all banks retained some recourse on their books, but at the 75th percentile is less than 5% of the asset value. Securitization income shows that only a few banks actively pursued securitization income in addition to traditional banking activities. That said, those that did securitize did so aggressively. At the 75th percentile securitization income is negligible but quickly jumps to a maximum of 58% of net income. 5. Methodology We run two sets of regressions, the first assessing a bank s risk using commonly known bank risk factors, while the second set exploits the clarity of hindsight to link executive pay to specific bank activities that contributed to the financial crisis. All regressions lag compensation variables by two years to address the endogeneity between contemporaneous compensation and bank risk. The two year lag structure allows enough time for compensation policies to affect the risks we investigate. One- and three-year lags were rejected for parsimony, as they yield no substantial improvements in model fitness. Our basic model follows: Risk Measure t = + ˇ 1 [Compensation Variables t 2 ] + ˇ 2 [Control Variables t ] + ε t We control for the firm-specific characteristics of size and market power with the natural log of total assets and Tobin s Q. Larger, more powerful firms are more likely to diversified in their income streams and therefore more likely to weather financial crises. Conversely, if firms are large enough to pose systemic risk, they might take on more risk if there is an implicit assumption that the government will not allow systemically important firms to collapse. We control for a change in the CEO during the year, as well as the age and tenure of the CEO to measure the effects of experience and distance to retirement. CEOs that are newer to their post and those who are relatively young, and therefore presumed to be further from retirement, may be more likely to decrease short-term risk and focus on long-term incentives. Conversely, elder CEOs would likely experience an increased short-term focus as they approach retirement, as their options and stock grants are largely vested and their wealth is decreasingly tied to the success of the bank. Thus, we predict that bank risk increases with CEO tenure and age. Overconfidence and hubris arguments also predict a positive relationship between tenure, age, and risk. We expect both of these factors to compress CEO planning horizons and promote short-term risk-taking activity. The first set of regressions tests the relationship between bank risk variables used in offsite monitoring programs and CEO compensation incentives. Our second series of regressions uses CEO compensation variables from 2004 to explain crisis-related bank activities in We use trading assets, OMBS, recourse, and securitization income from 2006, the good times when revenues produced from these risky activities were at their highest levels. Both sets of tests use cross-sectional OLS regressions, with Breush Pagan/Cook Weisberg tests to check for the presence of heteroskedasticity. When heteroskedasticity is present, we rerun the regressions with standard errors robust to heteroskedasticity. This is often the case with the crisiscentric risk variables of recourse, trading assets, other mortgage backed securities, and securitization income. In most cases the results are unaffected, and when the difference is significant we report the robust results. 6. Results The first set of regressions focus on the Federal Reserve s System to Estimate Examination Ratings (SEER) bank risk variables. Regressions are expanded to broaden the scope of the investigation each round such that short term, then long term, then all compensation variables are included in the regressions on bank risk. Table 3 reports results of regressions of short-term cash incentives, salary and bonuses, on SEER risk variables. Total cash compensation is not a statistically significant predictor of risk, though it approaches statistical significance with regard to decreased tangible capital.

9 Table 3 Regressions of total cash compensation on System to Estimate Examination Ratings (SEER) Federal Reserve risk variables. DelqLoan30d DelqLoan90+d NonAccruLoan ForclRealEst TangibleCapital OpIncome LoanLossResrv InvSecurities JumboCDs EDF Salary bonus tc (0.81) (0.64) (0.88) (0.84) (0.10) (0.75) (0.90) (0.82) (0.77) (0.77) Age * * ** ** (0.07) (0.07) (0.04) (0.41) (0.93) (0.73) (0.39) (0.05) (0.43) (0.67) Tenure ** * ** *** *** (0.02) (0.64) (0.05) (0.04) (0.33) (0.00) (0.27) (0.57) (0.00) (0.17) CEO change ** (0.11) (0.03) (0.90) (0.35) (0.26) (0.58) (0.68) (0.67) (0.39) (0.22) ln assets *** (0.84) (0.23) (0.16) (0.66) (0.00) (0.58) (0.81) (0.19) (0.29) (0.06) Tobin q *** *** *** * ** (0.00) (0.22) (0.00) (0.51) (0.27) (0.00) (0.06) (0.53) (0.25) (0.03) R N Cross-sectional regression of bank risk measures as of fiscal year 2008 explained by cash compensation and control variables lagged to DelqLoan30d and DelqLoan90d are the values of delinquent bank loans with a past-due period of or greater than 90 days, respectively, but still accrue interest and are therefore performing. NonAccruLoan is the value of loans that are no longer accruing interest. ForclRealEst is the book value of foreclosed real estate. TangibleCapital is bank equity less goodwill. OpIncome is net income less extraordinary items and gains (losses) on the sale of securities. LoanLossReserv is the value of reserves against losses in loans and leases. InvSecurities is the value of investment securities. JumboCDs is the value of all domestic certificates of deposit greater than $100,000. EDF is expected default frequency. Salary bonus tc is the sum of cash salary and bonus compensation as a percentage of total compensation. CEO change is a binary variable taking the value of 1 if the firm has a new CEO during the fiscal year and 0 otherwise. ln assets is the natural log of firm assets. Tobin q is Tobin s Q, a measure of market power wherein market valuation is compared to book value; a number greater than one indicates the market value of the firm is greater than the replacement cost of its assets. Numbers in parentheses are p-values. Values in bold are statistically significant, with the significance level indicated with asterisks. * Statistical significance at the 10% level. 464 J.C. Acrey et al. / Journal of Economics and Business 63 (2011) ** Statistical significance at the 5% level. *** Statistical significance at the 1% level.

10 Table 4 Cash compensation, CEO control, and SEER risk variables. DelqLoan30d DelqLoan90+d NonAccruLoan ForclRealEst TangibleCapital OpIncome LoanLossResrv InvSecurities JumboCDs EDF Salary bonus tc * (0.81) (0.66) (0.90) (0.81) (0.05) (0.77) (0.94) (0.87) (0.79) (0.68) Pct shr own *** * (0.86) (0.60) (0.73) (0.34) (0.01) (0.51) (0.20) (0.07) (0.54) (0.32) Age * * * (0.09) (0.07) (0.09) (0.24) (0.17) (0.55) (0.85) (0.30) (0.33) (0.39) Tenure * * ** *** (0.06) (0.89) (0.07) (0.18) (0.64) (0.03) (0.11) (0.16) (0.00) (0.49) CEO change ** (0.13) (0.04) (0.86) (0.44) (0.40) (0.52) (0.82) (0.48) (0.45) (0.18) ln assets *** ** (0.82) (0.21) (0.16) (0.79) (0.00) (0.51) (0.99) (0.30) (0.26) (0.04) Tobin q *** *** *** ** ** (0.00) (0.26) (0.00) (0.60) (0.11) (0.00) (0.04) (0.37) (0.22) (0.05) R N Cross sectional regression of bank risk measures as of fiscal year 2008, cash compensation and CEO bank ownership lagged to DelqLoan30d and DelqLoan90d are the values of delinquent bank loans with a past-due period of or greater than 90 days, respectively, but still accrue interest and are therefore performing. NonAccruLoan is the value of loans that are no longer accruing interest. ForclRealEst is the book value of foreclosed real estate. TangibleCapital is bank equity less goodwill. OpIncome is net income less extraordinary items and gains (losses) on the sale of securities. LoanLossReserv is the value of reserves against losses in loans and leases. InvSecurities is the value of investment securities. JumboCDs is the value of all domestic certificates of deposit greater than $100,000. EDF is expected default frequency. Salary bonus tc is the sum of cash salary and bonus compensation as a percentage of total compensation. Pct shr own is the percentage of outstanding firm shares owned by the CEO excluding shares represented by options holdings. CEO change is a binary variable taking the value of 1 if the firm has a new CEO during the fiscal year and 0 otherwise. ln assets is the natural log of firm assets. Tobin q is Tobin s Q, a measure of market power wherein market valuation is compared to book value; a number greater than one indicates the market value of the firm is greater than the replacement cost of its assets. Numbers in parentheses are p-values. Values in bold are statistically significant, with the significance level indicated with asterisks. * Statistical significance at the 10% level. ** Statistical significance at the 5% level. *** Statistical significance at the 1% level. J.C. Acrey et al. / Journal of Economics and Business 63 (2011)

11 466 J.C. Acrey et al. / Journal of Economics and Business 63 (2011) Table 4 repeats the previous regression but includes a variable measuring the percentage of outstanding shares owned by the CEO in order to capture the effects of long-term cumulative equity compensation on bank risk. Interestingly, short-term cash compensation becomes negative and significant with regard to tangible capital with the addition of CEO ownership, which is also negative and highly significant to tangible capital at the 1% level. Also, firms with high CEO ownership levels also show higher, marginally significant levels of investment securities relative to all assets. A 1% increase in CEO ownership decreases tangible capital by 0.88% and increases the percentage of investment securities to total assets by 3.54%. Table 5 reports regression results of cash compensation and the dollar value of shares owned by the CEO regressed on SEER bank risk variables. Cash compensation loses significance with regard to decreases in tangible capital but maintains the negative relationship. Higher CEO equity value retains the negative and statistically significant relationship to tangible capital and also shows a marginally significant relationship to increased expected default frequency. The compensation variables in our investigations are consistently overshadowed by the narrative generated by our control variables. We controlled for the age and tenure of the CEO, whether there was a change in the firm CEO that year, and for the size and market power of the firm. CEO age and tenure are positively and consistently significant with regard to non-accruing and delinquent loans and negatively significant with regard to operating income. These findings provide evidence that the older the CEO and the longer he or she has been at the firm, presumably then the closer to retirement and the more risky the bank. This provides some evidence of a short-term orientation on the part of older, tenured bank executives. We also find that the size of the firm is positively and significantly correlated with increased expected default frequency at the 5% level. This suggests that larger firms are more likely to default, providing evidence supporting the argument that insured deposits and, perhaps, the assumption on the part of bank executives that the largest firms are too big to fail, encourage moral hazard and the exploitation of the government safety net. However, market power as represented by Tobin s Q is negatively and significantly correlated to bank risk as represented by delinquent and nonaccruing loans and expected frequency of default and positively correlated with operating income, all at the 1% level. Table 6 broadens the investigation of CEO compensation and SEER risk variables by breaking compensation into its myriad components. Expected default frequency (EDF) is a measure of the probability of default within the next two years. It is therefore a short term risk metric whereas increases in EDF point to an increase in short-term risk. High salaries relative to total compensation, as expected, increase operating income and significantly decrease EDF at the 5% level. High bonuses, by themselves, are also shown to decrease EDF. However, high salaries in the presence of high bonuses, as represented by the interaction term, are positively and significantly correlated with expected default frequency at the 5% level. High bonuses, when coupled with high salaries, show a marked turn to short term risk taking; a 1% increase in this interaction term increases EDF by 3.37%, even though high salaries and high bonuses, independent of one another, show decreases in short term risk taking. A 1% increase in salary (bonus) as a percentage of total compensation decreases EDF by 0.46% (2.10%). Thus it is not bonuses per se that are the problem, but the combination of high salary and bonuses that may be cause for concern. Both share grants and vested shares are positively correlated with short term bank risk at the 10 and 5% levels, respectively, supporting the findings of Fahlenbrach and Stulz (2009) that CEO incentives are properly aligned with shareholders. A 1% increase in share grants or vested shares increases EDF by 0.43% and 0.01%, respectively. Options, both vested and unvested, are marginally but negatively correlated with short term risk, supporting the argument that option compensation properly provides long term incentives to managers. Table 7 reports results from the second vein of our investigation, where we relate compensation to the banking activities proven ex post to be contributors to the financial crisis. Compensation variables from 2004 are regressed on other mortgage backed securities, trading assets, net securitization income, and recourse variables in 2006 to capture any relationship between compensation and crisis-specific activity prior to the collapse of the real estate market, thus, at the height of these activities. We find no significant relationship between bonuses and risk, though the interaction between high bonuses and high salaries is a marginally significant predictor of higher trading assets relative to total bank

12 Table 5 Cash compensation, equity value, and SEER risk variables. DelqLoan30d DelqLoan90+d NonAccruLoan ForclRealEst TangibleCapital OpIncome LoanLossResrv InvSecurities JumboCDs EDF Salary bonus tc (0.93) (0.60) (0.92) (0.93) (0.17) (0.65) (0.98) (0.78) (0.64) (0.78) Total shr value ** * (0.61) (0.95) (0.63) (0.29) (0.01) (0.46) (0.83) (0.37) (0.77) (0.08) Age * * ** (0.06) (0.10) (0.04) (0.25) (0.30) (0.56) (0.46) (0.12) (0.39) (0.23) Tenure * ** *** (0.09) (0.69) (0.15) (0.20) (0.74) (0.03) (0.30) (0.37) (0.00) (0.88) CEO change ** (0.12) (0.03) (0.90) (0.37) (0.21) (0.58) (0.68) (0.67) (0.41) (0.19) ln assets *** ** (0.81) (0.23) (0.18) (0.63) (0.00) (0.62) (0.76) (0.16) (0.29) (0.04) Tobin q *** *** *** * ** (0.00) (0.19) (0.00) (0.49) (0.14) (0.00) (0.05) (0.41) (0.36) (0.04) R N Cross sectional regression of bank risk measures as of fiscal year 2008, cash compensation and CEO bank ownership lagged to DelqLoan30d and DelqLoan90d are the values of delinquent bank loans with a past-due period of or greater than 90 days, respectively, but still accrue interest and are therefore performing. NonAccruLoan is the value of loans that are no longer accruing interest. ForclRealEst is the book value of foreclosed real estate. TangibleCapital is bank equity less goodwill. OpIncome is net income less extraordinary items and gains (losses) on the sale of securities. LoanLossReserv is the value of reserves against losses in loans and leases. InvSecurities is the value of investment securities. JumboCDs is the value of all domestic certificates of deposit greater than $100,000. EDF is expected default frequency. Salary bonus tc is the sum of cash salary and bonus compensation as a percentage of total compensation. Total shr value is the value of the CEO equity portfolio as a percentage of total current year compensation. CEO change is a binary variable taking the value of 1 if the firm has a new CEO during the fiscal year and 0 otherwise. ln assets is the natural log of firm assets. Tobin q is Tobin s Q, a measure of market power wherein market valuation is compared to book value; a number greater than one indicates the market value of the firm is greater than the replacement cost of its assets. Numbers in parentheses are p-values. Values in bold are statistically significant, with the significance level indicated with asterisks. * Statistical significance at the 10% level. ** Statistical significance at the 5% level. *** Statistical significance at the 1% level. J.C. Acrey et al. / Journal of Economics and Business 63 (2011)

13 Table 6 Short and long term compensation components and SEER risk variables. DelqLoan30d DelqLoan90+d NonAccruLoan ForclRealEst TangibleCapital OpIncome LoanLossResrv InvSecurities JumboCDs EDF Salary tc * ** (0.77) (0.57) (0.52) (0.37) (0.17) (0.05) (0.88) (0.87) (0.38) (0.04) Bonus tc * * (0.20) (0.08) (0.91) (0.52) (1.00) (0.10) (0.70) (0.24) (0.62) (0.09) Bonus interactive * * *** (0.13) (0.09) (0.85) (0.53) (0.93) (0.07) (0.77) (0.33) (0.91) (0.05) Shr flow tc * (0.12) (0.42) (0.98) (0.75) (0.18) (0.37) (0.88) (0.30) (0.84) (0.08) Opt flow tc * *** (0.53) (0.09) (0.50) (0.13) (0.13) (0.90) (0.34) (0.71) (0.00) (0.69) Vested shr tc * ** (0.71) (0.53) (0.60) (0.92) (0.25) (0.34) (0.74) (0.14) (0.07) (0.02) Unvested shr tc ** * ** (0.20) (0.38) (0.51) (0.05) (0.09) (0.51) (0.74) (0.80) (0.03) (0.28) Vested opt tc * * (0.98) (0.15) (0.55) (0.19) (0.81) (0.86) (0.28) (0.06) (0.32) (0.06) Unvested opt tc ** * (0.86) (0.56) (0.50) (0.24) (0.49) (0.02) (0.16) (0.49) (0.14) (0.07) Age *** (0.39) (0.18) (0.20) (0.65) (0.51) (0.33) (0.93) (0.70) (0.23) (0.01) Tenure ** ** * *** (0.04) (0.49) (0.50) (0.05) (0.37) (0.09) (0.43) (0.21) (0.00) (0.72) CEO change * * ** (0.06) (0.14) (0.90) (0.38) (0.08) (0.10) (0.78) (0.60) (0.79) (0.05) ln assets ** (0.33) (0.10) (0.21) (0.42) (0.01) (0.35) (0.98) (0.31) (0.76) (0.31) Tobin q *** *** * *** * (0.00) (0.33) (0.00) (0.08) (0.38) (0.00) (0.07) (0.27) (0.22) (0.13) R N Dependent variables are 2008 bank risk measures. DelqLoan30d and DelqLoan90d are delinquent, interest-accruing bank loans or 90 days + days past due. NonAccruLoan are delinquent with no interest accrual. ForclRealEst is the book value of foreclosed real estate. TangibleCapital is bank equity less goodwill. OpIncome is net income less extraordinary items and gain/loss on sale of securities. LoanLossReserv is reserve against loan and lease losses. InvSecurities is investment securities. JumboCDs are domestic CDs ($100,000+). EDF is expected default frequency. Independent variables detail 2006 compensation and are normalized by dividing by total compensation (TDC1). Bonus interactive is the product of salary and bonus. Shr flow and opt flow are shares and options awarded during the year. Vested/unvested shares/options are the fair values of cumulative past awards of shares and options as of Option portfolio values are computed using the modified Black Scholes Merton methodology as per ExecuComp. CEO change is a binary variable = 1 if the firm has a new CEO in the fiscal year and 0 otherwise. ln assets is the natural log of assets. Tobin q is Tobin s Q, wherein market valuation is compared to book value. Numbers in parentheses are p-values. Values in bold are statistically significant, with the significance level indicated with asterisks. * Statistical significance at the 10% level. 468 J.C. Acrey et al. / Journal of Economics and Business 63 (2011) ** Statistical significance at the 5% level. *** Statistical significance at the 1% level.

14 J.C. Acrey et al. / Journal of Economics and Business 63 (2011) Table 7 Short and long term compensation components and crisis-specific bank risk behaviors. OtherMBS 2006 Trading Assets 2006 Net sec income 2006 Recourse 2006 Salary tc (0.22) (0.48) (0.89) (0.28) Bonus tc (0.99) (0.12) (0.24) (0.69) Bonus interactive ** (0.68) (0.02) (0.12) (0.86) Shr flow tc (0.13) (0.41) (0.92) (0.58) Opt flow tc (0.15) (0.50) (0.34) (0.49) Vested shr tc *** (0.80) (0.89) (0.00) (0.76) Unvested shr tc (0.38) (0.37) (0.80) (0.19) Vested opt tc ** (0.83) (0.92) (0.02) (0.56) Unvested opt tc (0.80) (0.96) (0.91) (0.40) Age ** (0.73) (0.55) (0.04) (0.56) Tenure (0.49) (0.95) (0.82) (0.19) CEO change *** (0.00) (0.27) (0.68) (0.12) ln assets ** *** (0.57) (0.04) (0.84) (0.01) tobin q * * (0.43) (0.08) (0.08) (0.68) R N The dependent variables are bank risk behaviors just before the crisis and presumably at relative high points, in The independent variables are CEO compensation separated into their components in 2004 together with the vector of control variables. OtherMBS is the value of other or private label mortgage backed securities not guaranteed by government backed agencies. Trading Assets is the value of all marketable securities held for trading purposes including mortgage backed securities and credit default swaps. %SecuritzInc is the percentage of income resulting from securitization activity. Recourse is the value of guarantees made by the bank to the buyers of securitized products and includes financial standby letters of credit, performance standby letters, recourse and direct credit substitutes, and other assets sold with recourse. Executive compensation data are from Compustat ExecuComp. All compensation variables are normalized by dividing by total compensation (TDC1), defined as salary, bonus, all other, total value of restricted stock grants, total value of option grants, and long term incentive payouts in Bonus interactive is the product of salary and bonus divided by total compensation. Shr flow and opt flow are the shares and options values, respectively, awarded during the year. Vested/unvested shares/options are the fair values of cumulative past awards of shares and options, either vested or unvested, as of Option portfolio values are computed using the modified Black Scholes Merton methodology as per ExecuComp. CEO change is a binary variable taking the value of 1 if the firm has a new CEO during the fiscal year and 0 otherwise. ln assets is the natural log of firm assets. Tobin q is Tobin s Q, a measure of market power wherein market valuation is compared to book value; a number greater than one indicates the market value of the firm is greater than the replacement cost of its assets. Numbers in parentheses are p-values. Values in bold are statistically significant, with the significance level indicated with asterisks. * Statistical significance at the 10% level. ** Statistical significance at the 5% level. *** Statistical significance at the 1% level. assets. Vested shares are positively and significantly correlated with securitization income at the 1% level, though vested options are negatively correlated with securitization income at the 5% level. Not surprisingly, larger firms were more likely to have higher levels of trading assets and to hold recourse on their books at the 5 and 1% levels, respectively. Once again, however, firms with more market power were marginally less likely to have higher percentages of trading assets and securitization income.

15 470 J.C. Acrey et al. / Journal of Economics and Business 63 (2011) The negative relationship between high market power as represented by Tobin s Q and bank EDF, SEER risk variables, and crisis specific measures of risk is somewhat puzzling. In short, Tobin s Q measures how much the market values a bank s assets relative to the replacement cost of those assets. One might think that the market was especially valuing those activities that compounded the crisis, for example the securitization of mortgage backed securities, yet our evidence suggests that this is not the case even pre-crisis. This finding bolsters the argument that the market more often than not properly assigns value to firm shares, regardless of hype or the possibility of asset bubbles. 7. Conclusion The financial crisis and subsequent taxpayer-funded bank bailouts fueled public outrage at bank CEO compensation incentives. Bankers were handsomely compensated despite presiding over a systemic banking crisis. Public demands to punish the guilty and fix the system were clearly heard in Washington. Yet, academic research has yet to conclusively tie CEO pay bank risk. We examine the links between short-term CEO compensation practices and bank risk during the financial crisis. We find little evidence that bonuses create perverse incentives to increase risk-taking. Un-exercisable options seem to mitigate bank risk, a finding conflicting with consensus and extant literature. CEO tenure, however, seems to both increase risky activities and decrease tangible capital and net income. We conclude that bonuses and options did not seem to increase risk, and they may have even dampened some of the socially undesirable, high-risk activities of banks. Thus, we advocate caution; further research on banking incentives is needed before we fix what may not be broken. Acknowledgements We are grateful to FISS 2010 participants at the University of Victoria, BC, Tim Yeager, and an anonymous reviewer for helpful comments and suggestions. References Agrawal, A., & Mandelker, G. N. (1987). Managerial incentives and corporate investment and financing decisions. The Journal of Finance, 42, Bebchuk, L. A., & Spamann, H. (2009). Regulating bankers pay. Discussion Paper No Brewer III, E., Hunter, W. C., & Jackson III, W. E. (2004). Investment opportunity set, product mix, and the relationship between bank CEO compensation and risk-taking. Federal Reserve Bank of Atlanta. Working Paper Bryan, S., Hwang, L., & Lilien, S. (2000). CEO stock-based compensation: An empirical analysis of incentive-intensity, relative mix, and economic determinants. Journal of Business, 73(4), Cheng, I., Hong, H., & Scheinkman, J. (2009). Yesterday s heroes: Compensation and creative risk-taking. Working paper. Clementi, G. L., & Cooley, T. F. (2009). Executive compensation: Facts. NBER Working Paper Series. Cole, R. A., & Gunther, J. W. (1995). FIML: A new monitoring system for banking institutions. Federal Reserve Bulletin. Crosbie, P., & Bohn, J. (2003). Modeling default risk. Moody s KVM Company. Cuomo, A. M. (2009). No rhyme or reason: The Heads I Win, Tails You Lose bank bonus culture. New York: New York State Attorney General s Office. Douglas, A. V. (2006). Capital structure, compensation and incentives. The Review of Financial Studies, 19(2), Fahlenbrach, R., & Stulz, R. (2009). Bank CEO incentives and the credit crisis. Ohio State Working Paper. Gilbert, R. A., Meyer, A. P., & Vaughan, M. D. (2000). The role of a CAMEL downgrade model in bank surveillance. Federal Reserve Bank of St. Louis Research Division. Working Paper A. Gomstyn, A. (2009). Wall street roller coaster means big CEO paydays: Two dozen bank execs see compensation jump $90M through stock options. ABCNews.com. Retrieved from Gorton, G. (2009). Slapped in the face by the invisible hand: Banking and the panic of In 2009 financial markets conference: Financial innovation and crisis May 11 13, Houston, J. F., & James, C. (1995). CEO compensation and bank risk: Is compensation in banking structured to promote risk taking. Journal of Monetary Economics, 36, Jeitschko, T. D., & Jeung, S. D. (2005). Incentives for risk-taking in banking: A unified approach. Journal of Banking & Finance, 29(3), Levine, R. (2004). The corporate governance of banks: A concise discussion of concepts and evidence. Policy, Policy Research Working Paper Series. Murphy, K. J. (1999). Executive compensation. Handbook of Labor Economics, 3,

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