9.

CEO pay and risk-taking in banking: The roles of bonus plans and deferred compensation in curbing bank risk-taking Jens Hagendorff and Francesco Vallascas

Jens Hagendorff* University of Edinburgh (UK) Francesco Vallascas University of Leeds (UK) & University of Cagliari (Italy)

This version: 10 December 2010

Abstract
The use of incentive pay in banking is widely believed to have motivated excessive risktaking and to have acted as a contributory factor to the recent financial crisis. This chapter critically reviews existing empirical work on the relationship between CEO pay and bank risk-taking and argues that previous work has been too narrow in its focus on equity-linked CEO compensation (mainly share and option grants) while neglecting common forms of CEO compensation which are not equity-linked (particularly pensions and other forms of deferred compensation). This chapter argues that it is regrettable that not more is empirically known about the risk effects generated by non-equity (and essentially more debt- like) forms of compensation and calls for debt-like components of CEO compensation to be examined in greater detail by both researchers and policymakers.

Corresponding author. University of Edinburgh Business School, 29 Buccleuch Place, Edinburgh EH8 9AL, UK. Tel. +44 (0)131 650 2796. e-mail: jens.hagendorff@ed.ac.uk.

1. Introduction
Executive compensation policy may serve as a mechanism to reduce conflicts between managers and shareholders over the deployment of corporate resources and the riskiness of the firm (Jensen and Meckling, 1976, Shleiffer and Vishny, 1997). Public and academic interest in CEO compensation in the banking industry has increased exponentially in the aftermath of the financial crisis of 2007-08. While this is partly motivated by public outrage over the levels of CEO remuneration in an industry that has become increasingly reliant on public funds, the view that the structure of executive pay has given rise to socially harmful risk-taking by banks is gaining ground. Thus, the use of incentive pay in banking is widely believed to have motivated excessive risk-taking and to have acted as a contributory factor to the recent financial crisis (e.g., Bebchuk and Spamann, 2009; IMF, 2010, Federal Reserve Bank, 2010). Understanding the relationship between CEO pay and bank risking-taking matters. It matters because of the importance of banks to any monetary economy and because taking risks is a key component of many of the activities performed by banks. Furthermore, optimally designed incentive compensation is essential to induce managerial effort by incentivizing bank CEOs to commit to risky but positive net present value (NPV) projects (Jensen and Meckling, 1976; Amihud and Lev, 1981; Smith and Stulz, 1985). Finally, understanding the pay-risk relationship also matters, because CEO pay at banks has become subject to increasing levels of government intervention in the aftermath of the recent financial crisis. As regards recent government interventions into pay in banking, Europe has taken a rather prescriptive approach to this, mainly by introducing caps or punitive taxes on CEO pay. For instance, in Germany CEO compensation at banks which receive state aid has been capped at 500,000 euros. Dutch banks have agreed to limit cash bonuses to 100% of base salary. Both the

2 UK and France have introduced a 50% tax on bonuses paid during 2009. Further, pending European Union (EU) legislation will dictate that bonus awards above a certain level must defer payment of a fixed fraction. In response to these EU guidelines, the UKs Financial Services Authority (FSA) has announced that at least 40% of bonus payments made to senior management at a wide range of financial services firms must be deferred for a period of at least three years from 2011. Further, non-equity based bonus payments to the CEOs of UK financial firms will be limited to 50% of total compensation with the remainder payable in equity and equity-like instruments. By comparison, the US approach to compensation has been more principle-based and less prescriptive. Excluded from the principle-based approach are banks which receive government support under the Troubled Asset Relief Program (TARP). At TARP recipients, executive compensation packages require approval from a pay master until the funds have been completely repaid. However, generally the US approach to regulating CEO pay in banking is based on requiring banks to provide balanced risk-taking incentives to senior risk management staff. However, the guidelines for senior executives at large banking organizations (LBOs) come close to dictating that bonuses be paid in equity-based instruments, that the payment be deferred and that vesting be performance-contingent. The US guidance on compensation practices as published by the Federal Reserve Bank (2010, pg 33) advises that Incentive compensation arrangements for senior executives at LBOs are likely to be better balanced if they involve deferral of a substantial portion of the executives incentive compensation over a multi-year period in a way that reduces the amount received in the event of poor performance, substantial use of multi-year performance periods, or both. Similarly, the compensation arrangements for senior executives at

3 LBOs are likely to be better balanced if a significant portion of the incentive compensation of these executives is paid in the form of equity-linked instruments that vest over multiple years, with the number of instruments ultimately received dependent on the performance of the organization during the deferral period. Federal Reserve Bank, 2010, pg. 33 While less prescriptive, the US approach to CEO pay in banking displays a similar preference for equity over non-equity types of compensation as European approaches. However, little is empirically actually known to date about the effects of non-equity types of pay on bank risk. Most importantly, recent empirical findings openly challenge the wisdom of paying bank CEOs with equity-like forms of compensation at the expense of non-equity linked compensation. Non-equity based forms of CEO compensation are widespread and include CEO bonus plans and CEO pension entitlements under a defined benefit scheme. Both CEO bonus payments (e.g., Noe et al., 1996, Balachandran et al. 2010) and CEO pension entitlements (e.g. Edmans and Liu, 2010; Wei and Yermack, 2010, Tung and Wang, 2010) have been linked to lower bank risk in recent academic work. This chapter critically reviews existing empirical work on the relationship between CEO pay and bank risk-taking and argues that previous work has been too narrow in its focus on equity-linked CEO compensation (mainly share and option grants) while neglecting common forms of CEO compensation which are not equity-linked and which could make a valuable contribution to promote socially optimal risk-taking by banks. Research which examines nonequity components of CEO compensation, particularly pensions and other forms of deferred compensation, is still in its infancy (see Balachandran et al., 2010, Yermack and Wei, 2010). However, many of the findings which are proffered by this stream of research are consistent with

4 the view that, where equity-based pay encourages risk-taking, non-equity linked pay makes CEOs more risk-averse (see Edmans and Liu, 2010). This chapter argues that it is regrettable that not more is empirically known about the risk effects generated by non-equity (and essentially more debt- like) forms of compensation and calls for debt-like components of CEO compensation to be examined in greater detail. The remainder of this chapter is organized as follows. The next section provides an overview of the increasing importance of equity-linked compensation in the US banking industry over recent times and argues that empirical evidence supports the view that more equity-based compensation is linked to riskier banks. Section 3 makes the case for paying bank CEOs using bonus plans and deferred compensation and explains why non-equity forms of compensation offer a promising way of mitigating CEO appetite for risk and to promote socially responsible risk-taking in the banking industry. The final section offers some conclusions and policy implications.

2. Equity-linked compensation and its effect on CEO risk-taking

2.1. The state we are in Over recent decades, the use of equity-linked compensation has increased rapidlyboth inside and outside the banking industry. Equity-linked CEO compensation takes the form of grants of the firms shares as well as call options on the firms equity. Option grants in particular make CEO wealth sensitive to risk-taking. Call options combine unlimited upside with limited downside potential and, therefore, provide convex CEO payoffs linked to marginal increases in bank risk. DeYoung et al. (2010) show that the use of equity-linked compensation in US banking has increased so rapidly over the last decade that CEO payoffs linked to increases in firm risk are now higher in the banking industry than in other industries. DeYoung et al. (2010) calculate that

5 the average bank CEO saw her wealth increase by around $300,000 in 2004 as a result of a 0.01 increase in stock return volatility. For US CEOs in non-financial firms, the dollar amount linked to marginal increases in risk was about a third less in 2004. There are two explanations which are frequently cited for the marked increase in equitylinked compensation in US banking. Theoretical arguments over the optimal riskiness of a firm suggest the use of risk-sensitive compensation is consistent with agency theory. Agency theory postulates that optimal executive compensation needs to align the interests of risk-averse managers with those of risk-neutral shareholders by motivating managers to commit to riskincreasing but positive NPV projects (Jensen and Meckling, 1976; Amihud and Lev, 1981; Smith and Stulz, 1985). CEO performance contracts need to sufficiently motivate bank CEOs to take advantage of this growing investment opportunity set (Smith and Watts, 1992; Mehran and Rosenberg, 2007). In most countries, the range of commercial activities that banking firms may engage in has increased to include various capital market activities as well as insurance underwriting. One way of motivating CEOs to participate in these new opportunities is to increase their share of equity-linked compensation in the banking industry. Put differently, increases in the risk sensitivity of executive compensation were designed to encourage bank managers to exploit various new financial activities, typically fee-based and more risky than traditional banking activities (see Stiroh, 2006), which deregulation had opened up. Mehran and Rosenberg (2007) and DeYoung et al. (2010) interpret the fact that large increases in equitylinked compensation can be found for US bank CEOs in the period immediately following the deregulation of banking activities as consistent with this view. The second explanation for the increase in equity-linked compensation takes a more negative view of the role of bank CEO compensation packages and argues that CEO

6 compensation has increasingly been designed to encourage CEOs to shift risk onto bondholders and regulators. Since banks are leveraged institutions, shareholders benefit from higher-risk investment choices which increase the potential value of bank assets, while keeping the downside risk limited (John and John, 1993; Bebchuk and Spamann, 2009). Therefore, shareholders will use their control over incentive compensation in order to encourage higher risk-taking and, effectively, to shift risk onto bondholders (whose payoffs will not increase with higher bank risk) and regulators (that guarantee the financial safety net which is likely to be called upon in the event of institutional failure). The next section discusses the empirical literature on the risk effects of equity-linked compensation. A distinction is made between CEO option holdings (where the empirical evidence strongly suggests that these are linked to higher bank risk) and CEO shareholdings (whose risk effects are much less clear-cut). 2.2. Previous literature on the risk-taking effects of equity-linked compensation Previous work on the effects of CEO option holdings on bank risk-taking is relatively unambiguous with regards to the implications that option holdings have for the risk preferences of bank CEOs. Generally, the non-financial literature finds that increased sensitivity of CEO pay in remuneration packages causes CEOs to make riskier investment choices (Rogers, 2002) and bind corporate resources to riskier activities (Nam et al., 2003; Coles et al., 2006; Rajgopal and Shevlin, 2002; Guay 1999). In the US banking industry, the empirical evidence is also supportive of CEO option holdings being associated with higher banking risk. Mehran and Rosenberg (2007) and DeYoung et al. (2010) show that when the sensitivity of option values to risk-taking is higher, banks engage in riskier types of activities. Chen et al. (2006) find a positive relationship between the value of stock options granted to CEOs and market measures of banking

7 risk. Hagendorff and Vallascas (2010) show that bank CEOs whose wealth is more sensitive to risk-taking engage in bank mergers that increase the probability of default of the acquiring bank post-M&A. One exception to the literature which is otherwise almost univocal in finding that equity-based CEO compensation has a risk-increasing effect is a recent study by Fahlenbrach and Stulz (2010). The authors are not able to find a link between equity-based risk incentives and the performance of bank stocks during the recent financial crisis. Fahlenbrach and Stulz (2010) interpret their results as consistent with the view that there is no link between equity-based CEO compensation and pre-crisis CEO risk-taking. Next to options, equity grants also provide a way of aligning managerial and shareholder interests. However, the implications of share ownership on bank riskiness are theoretically and empirically much more ambiguous than those of CEO option holdings. The main reason for this is that, unlike options, the CEO payoffs linked to share holdings are not highly convex. On the one hand, this means that larger managerial shareholdings may well overcome CEO risk adversity and incentivize CEOs to identify and commit to risky and positive NPV projects. However, on the other hand, larger CEO shareholders will expose managers to company risk to a much larger degree than diversified shareholders and this could aggravaterather than overcomemanagerial risk-aversion (Smith and Stulz, 1985; Amihud and Lev, 1981). DeYoung et al. (2010) find some evidence that high share ownership by the CEO reduces the riskiness of bank activities, while Mehran and Rosenberg (2007) do not detect any robust influence of CEO ownership on risk-taking. For the banking industry, Bliss and Rosen (2001) and Minnick et al. (2009) show that banks whose CEOs have large shareholding in the bank that they run are less likely to engage in acquisitions. This is consistent with banks whose CEOs own a share of the banks equity forgoing risky investment projects such as M&A.

8 In sum, the empirical evidence discussed above is inconsistent with the regulatory aim of employing more equity-based compensation to control managerial risk-appetite. The literature in this area only offers some limited evidence that CEO shareholdings may be associated with lower banking risk, while the consensus finding on option grants is that these are associated with measurable increases in bank risk.

3. Non-equity based compensation and bank risk

Non-equity based forms of compensation provide an interesting route to offer incentives to CEOs which, unlike equity-linked forms of compensation, are not characterized by the sort of convex payoffs which reward increases in bank risk. Below, this section proffers a discussion of how CEO bonus plans and deferred compensation effect banking risk. 3.1. CEO bonus plans CEO bonus plans are an interesting case. In sharp contrast to public opinion and also many of the regulatory proposals that emerge for the future regulation of pay in banking (some of these are discussed above), neither theoretical nor empirical work supports the view that CEO bonuses promote risk-taking in general (Smith and Stulz, 1985; Duru et al. 2005; Kim et al. 2008). The main reason for this is due to the payoff structure of CEO bonus plans. A typical CEO cash bonus becomes payable once earnings-based targets are met over a one-year period. The key point is that above that threshold, the payoff increases with performance up to a maximum payout (cap). Therefore, for bank performance above the threshold at which bonus payments become payable, CEO payoffs from executive bonus plans are not convex with respect to performance. Duru et al. (2005) argue that earnings-based cash bonuses make managers seek stable cash flows to meet contractual debt obligations. The authors show that the costs of debt financing decrease at firms where CEOs receive higher cash bonus payments. Duru et al. argue

9 that higher bonus payments reduce agency conflict with debt holders and, thus, lower the riskshifting incentives in these firms. Admittedly, one implication of the more or less binary payoff structure of CEO bonus plans is that when firm performance is below the earnings-based threshold at which bonus payments become payable, the payoff function for a CEO turns convex and will incentivize CEOs to take risk in order to secure a bonus payment (see Smith and Stulz, 1985). Kim et al. (2008) confirm these theoretical arguments by estimating the performance thresholds underlying CEO bonus plans and show that CEOs display increased risk-taking behavior where current levels of corporate performance place a CEO just underneath the performance threshold at which a bonus becomes payable. Further, in the banking industry, the presence of regulation and safety nets means that there are two additional conditions under which CEO cash bonuses may indeed promote riskshifting. First, cash bonuses aggravate risk-shifting incentives where the prospect of regulatory intervention is low (Noe et al. 1996). For instance, Webb (2008) argues that bank executives become more risk averse where the intensity of regulatory monitoring is high. Consequently, where regulatory environments are less strict and regulatory intervention unlikely, executives will be more responsive to pay-based incentives to take on excess risk. Second, cash bonuses promote managerial risk-shifting at distressed banks (Noe et al., 1996; Benston and Evan, 2006). Since bonus payments to CEOs are solvency-contingent, they incentivize CEOs to engage in a gamble for resurrection by engaging in risky projects whenever institutional default seems likely. In these cases, bonus payments insulate CEOs at distressed banks from the longer-term negative effects of high-risk, negative NPV projects (Duru et al., 2005).

10 The narrow empirical literature available on the role of CEO bonus payments and bank risk reaches conflicting conclusions. Harjoto and Mullineaux (2003) report a positive association between bonus payments and the return volatility of bank equity. In a recent paper, Balachandran et al. (2010) show evidence that the sum of bonus and other cash incentives reduces the probability of bank default. This is in contrast to Ayadi et al. (2011) who show for a sample of European banks that the presence of long-term bonus plans is associated with higher risk (on the basis of z-scores). Vallascas and Hagendorff (2010) examine the risk effects of CEO cash bonus plans for a sample of US and European banking firms. The results show that CEO cash bonuses reduce bank default risk. Consistent with the theoretical arguments proffered above, their results also show that the risk-reducing effect of CEO cash bonuses is particularly pronounced in stronger regulatory environments and for non-distressed financial institutions. 3.2. Deferred compensation One of the key features of CEO cash bonuses is that, because the payoffs for CEOs are not convex functions of performance, they do not reward CEO risk-taking and, therefore, have the potential to more closely align managerial risk preferences with those of debtholders. It follows from this that if there are benefits linked to aligning the interests of debtholders and management, these could equally be realized by paying CEOs directly with debt. Debt as a form of executive remuneration is widespread. It tends to take the shape of deferred compensation, most notably in the form of defined benefit pensions (see Sundaram and Yermack, 2007; Wei and Yermack, 2009). These company promises of fixed sums at some future point in time are unfunded and unsecured CEO claims. In the US and many other countries, the deferred compensation claims of executives take no priority over the claims of other unsecured creditors in the event of bankruptcy. The value of deferred compensation claims

11 by CEOsalso known as inside debt (Jensen and Meckling, 1976)can make up a substantial share of a CEOs overall remuneration. Wei and Yermack (2010) report that out of the S&P 1500 firms, more than two-thirds of CEOs hold some form of inside debt and that for those who hold inside debt, the holdings were worth an average of $5.7 million in 2006. The key argument for why inside debt can play an important part as a remedy against CEO risk shifting incentives is that rather than merely giving CEOs an interest in the survival of the firm (as solvency-contingent cash bonuses do), inside debt gives CEOs a financial interest in the liquidation value of the firm (Edmans and Liu, 2010). As explained above, where firms are close to failure, CEO cash bonuses may cause managers to engage in a gamble for resurrection even if the most likely outcome of this gamble will be that firms will survive for one more period of bonus payments. Inside debt, by contrast, gives CEOs incentives not only to avoid institutional failure, but also to maintain high asset values such that company promises made to them as well as to other unsecured creditors can be honored. A small number of empirical studies report evidence consistent with inside debt curbing CEO risk-taking behavior. Sundaram and Yermack (2007) find that large inside debt positions by a CEO reduce the probability of default on a firms debt. More recently, Wei and Yermack (2010) examine the bond and share price reaction to the disclosure of inside debt holdings in 2007 as mandated by the Security and Exchange Commission (SEC). The authors find that large CEO pensions (as well as other forms of deferred payments to CEOs) are associated with gains for bond holders and losses for shareholders. Wei and Yermack (2010) argue that shareholder wealth losses in the time period after the disclosure of large inside debt holdings are consistent with the view that such holdings reduce firm risk and, therefore, the expected returns from holding equity.

12 Tung and Wang (2010) provide the hitherto only examination of the risk-taking effects of inside debt holdings in the banking industry. Their analysis is limited to the time period 2006 2008 and shows bank CEOs with higher inside debt holdings engaged in less risk-taking before the financial crisis (as indicated by better stock market performance during the financial crisis). There is a clear need for further research to look at the risk-taking effects of inside debt holdings over longer examination periods. The recently enhanced disclosure requirements by the SEC as regards deferred compensation claims by CEOs will provide a wealth of new opportunities for researchers to examine the effects of paying CEOs with debt. However, even before the enhanced disclosure requirements became active in 2007, the proxy statements filed with the SEC contain sufficient information to estimate the expected present value of a CEOs pension using actuarial computations (see Sundaram and Yermack, 2007). Some of the questions which future research should address relate to the conditions under which managerial holdings of inside debt have a risk-reducing effect as discussed in the following two paragraphs. One question which future research should address is whether the risk-reducing effects of inside debt reverse where banks are distressed and close to default. In other words, does debt-like compensation have a risk-inducing effect at risky banks, because the incentive effects of debtlike incentives are akin to those of equity at these institutions? Also, the personal circumstances and overall structure of CEO compensation will need to be taken into account to a larger degree by future research. Typically, pension entitlements make up the bulk of deferred compensation claims by CEOs. While the actuarial value of pension entitlements will be largest for CEOs closer to retirement, the risk-reducing effects of similar levels of pension entitlements may well be largest for CEOs which are closer to retirement. Further, a CEO with substantial amounts of equity-linked compensation will arguably be less likely to be concerned with payoffs from a

13 pension scheme and other types of deferred compensation. Consequently, for CEOs with large amounts of equity-linked pay, deferred compensation may not be effective in reducing banking risk. Ultimately, the question whether an optimal balance exists between equity and debt-based CEO compensation and what this optimal balance is should be addressed in future compensation research. Relatedly, because defined benefit schemes give CEOs an interest in the asset value of the firm long after they retired, future research could also examine the effect of inside debt on CEO succession. It is conceivable that CEOs who are close to retirement with high inside debt holdings are succeeded by a safe pair of hands which are likely to pursue low-risk strategies. All of these are interesting questions which can be addressed using publicly available compensation data (at least of US bank CEOs). If future work on inside debt holdings confirms the results reported above for the banking industry, this has important policy implications. Generally, the results based on pension data back the notion that deferred compensation should form an integral part of CEO compensation and that deferred compensation is most effective in curbing risk shifting where the deferral period spans over many years (as in the case of defined benefit pensions).

4. Concluding remarks
This chapter critically reviews the existing literature that links the structure of CEO compensation to bank risk-taking. While this literature has grown considerably in recent years, it remains solemnly focused on the role of equity-linked compensation. That is, previous work on banking almost exclusively examines the impact that paying CEOs with option and equity grants has on banking risk. This focus on equity-linked pay is regrettable, given that non-equity linked forms of compensation bear potential to reign in much of the socially suboptimal risk-taking in

14 the banking industry which is now widely seen as a contributory factor to the recent financial crisis. This chapter argues that, while the extant work has made important contributions to aid a better understanding of the pay-risk relationship in banking, it should not be forgotten that nonequity based forms of compensation warrant empirical investigation. This is because the payoff structure of CEO bonus plans or deferred compensation is very different from that of equitylinked pay. The payment of CEO bonus plans is contingent on the bank remaining solvent and the payout value of deferred compensation claims by a CEO is dependent on the liquidation value of the bank. In the case of CEO pension rights and other forms of deferred compensation, it could easily be argued that these CEO claims turn managers into bondholders who, because they join the ranks of the other unsecured creditors, have a financial interest to maintain high liquidation values of bank assets and, thus, low levels of risk. The work discussed in this chapter backs the notion that increasing the degree to which managerial interests are aligned with those of debtholders reduces the agency costs of debt and, therefore, lowers managerial incentives to shift risk. As far as the role of CEO bonus plans is concerned, the work discussed in this chapter comes to conclusions which are inconsistent with many of the recent policy initiatives in the US as well as a number of European countries. The view underlying many of these initiatives is that high bonuses are undesirable and, in the case of many European economies, should be subject to high levels of taxation. A potentially risk-reducing role of CEO bonus plans has not entered the public debate on this matter. Similar arguments apply to the role of CEO pension entitlements. While deferred compensation is a key pillar of how payment practices at large banking firms are

15 likely to be reformed, the role that pension entitlements can play in this context has not entered the public debate on this matter either. Finally, the focus of existing work on the US means that cross-country differences in regulation and safety net subsidies to banking firms will not be adequately considered if empirical findings based on the US market are applied to other countries. For instance, it could be argued that in the presence of a generous and effective provision of deposit insurance system as the one provided by the Federal Deposit and Insurance Corporation (FDIC) in the US, shareholders are less than adequately monitored by other bank creators and face more incentives to encourage bank risk-taking via CEO compensation contracts that are more sensitive to risktaking. Compensation at banking firms is an important topic. Previous research in this area has pointed out that equity-linked compensation in an industry that is highly-leveraged and enjoys safety net subsidies will aggravate risk-shifting incentives faced by CEOs. It will now be up to future work to understand how the structure of managerial compensation can be employed to cushion and manage CEO risk-taking incentives. Moving the focus away from equity and towards debt-like forms of CEO remuneration offers a promising route for thisfor both researchers and policymakers.

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