The global financial crisis that began unfolding in 2007 has focused attention once again on the consequences of bank managers’ unprofitable risk taking. In retrospect, it seems clear that many banks took excessive risks in the mid-2000s. Responding to recent losses suffered by U.S. banks and anticipated costs to U.S. taxpayers, many observers have argued that poorly structured bank executive compensation led to excessive risk taking by bank managers. President Barack Obama and Treasury Secretary Timothy Geithner have both made this claim. Financial institutions that received “exceptional” TARP assistance by now are subject to increased executive compensation regulation. Finally, bank CEO bonuses have come under particular fire by many critics who claim this form of compensation is either unrelated to performance or induces risk taking.
Prior researchers have investigated various factors that influence managerial incentives and managerial risk taking in banks. Risk taking by bank managers holds particular interest because of the important role banks play in financing modern economies, because of the government guarantees (explicit and implicit) covering certain bank liabilities, and because of the well-known incentive to take excessive risk that such guarantees create. Accordingly, many stakeholders, including regulators, lawmakers, shareholders, and taxpayers, stand to benefit from a deeper understanding of the factors related to bank manager risk taking. In this study, we focus on three factors that potentially influence risk taking by bank managers: ownership structure, executive compensation, and governance.
The agency theory literature provides a natural starting point from which to analyze bank managers’ incentives. Bank managers, like managers of non-financial firms, are likely to have firm-specific human capital and are likely to enjoy private benefits of control. These two characteristics can create incentives for bank managers to take less risk than outside shareholders prefer. However, bank ownership structure can alter managerial incentives for risk taking. If share ownership is concerted in the hands of outside block holders, these owners can put pressure on bank managers to increase risk. In addition, as bank managers’ share ownership increases, their interests can become more aligned with those of outside shareholders and thus motivate bank managers to increase risk. A positive relationship between managerial ownership and bank risk taking is not predetermined, however. As managerial ownership increases, managers become less diversified. With more and more of their total (human and financial) capital dependent on the bank’s performance, bank managers can exhibit greater risk aversion as their share ownership increases.
All things equal, options-based executive compensation is expected to increase managerial incentives to take risk because volatility in the underlying share price increases option value. Base salary increases likely induce managerial risk aversion because that compensation component establishes a steady stream of cash flows similar to those received by senior debt holders. The influence of cash bonuses on managerial risk aversion is less clear because that influence should depend on the specific design of the bonus plan.
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