Designing Executive Compensation to Curb Bank Risk Taking

Hamid Mehran

The financial crisis and its aftermath have spurred calls for bank compensation packages that mitigate risk-taking incentives. In this post, I review some of the issues linking executive compensation and risk and then describe a novel scheme that links executive pay to credit default swap (CDS) spreads. As I will argue, compensation reform that includes risk-based measures can be effective and efficient in addressing policy concerns about excessive risk taking.

Compensation and Risk

We start with the base case of a flat salary—an annual amount of money received by a firm’s chief executive officer regardless of the performance or riskiness of the firm. What happens if some of that salary is replaced with company stock or options? The theoretical basis for executive compensation through stock and options is that the stock price is an objective measure of a CEO’s performance, and so a CEO’s objectives can be aligned with shareholders’ by giving CEOs “skin in the game” through stock-price-sensitive pay. While we may worry that a CEO receiving fixed compensation will not expend any effort, including stock and/or options may offset this shirking problem.

If stock represents a significant percentage of the CEO’s personal wealth, we may expect that executive to be more mindful of risk. However, if the stock price of a firm does not accurately reflect the riskiness of the firm, the executive may remain risk-neutral or even become more risk-seeking as compensation includes a higher percentage of stock. Leverage is an easy way for firms to increase both their returns (and through returns, profits and share price) and their riskiness.

Should Bank Executives Receive Company Stock?

The rationale for stock-based compensation may apply to nonfinancial firms with low levels of leverage, but it may not be relevant to financial institutions for two fundamental reasons. First, banks are highly levered institutions, with leverage ratios that often exceed 90 percent. Second, banks are regulated entities that can rely on both explicit and implicit guarantees on their leverage, and as such their share prices may not accurately represent their riskiness. Thus, when designing bank executive compensation, one must consider the interests of creditors, depositors, and taxpayers in addition to equity holders. This is particularly important because of deposit insurance subsidies that reduce the bank’s borrowing rate and may distort other market proxies of a bank’s riskiness. (For more on this point, see Adams and Mehran.)

If anything, bank CEOs and their shareholders may favor excessive risk taking. Owners of common stock in a highly levered institution with a significant failure risk effectively own a call option that is in-the-money when the bank is solvent and out-of-the money when it goes bust. The value of a call option is increasing in the volatility of the underlying stock price. All else equal, shareholders in highly levered institutions should thus generally favor excessive risk taking, especially when the bank approaches financial distress.

Tying Compensation to Credit Default Swap Spreads

Because stock- and options-based compensation is unlikely to curb the risk appetites of bank executives, Bolton, Mehran, and Shapiro in a 2010 New York Fed working paper proposed tying remuneration to a bank’s credit default swap spread. An institution’s CDS spread provides a market measure of the risk of a bank. Under our scheme, a high or increasing CDS spread would translate into a lower cash bonus, and vice versa. For banks that do not have a liquid CDS market, the bonus could be tied to the institution’s borrowing cost as proxied by the debt spread. However, the CDS spread has the benefit of being market based, and can be chosen optimally. It is the closest analogue a bank has to a stock price—it is the market price of credit risk. If CEO deferred compensation were tied directly to the bank’s own CDS spread, bank executives would have a direct financial exposure to the bank’s underlying risk and would have an incentive to reduce risk that does not enhance the value of the enterprise. Returning to our stylized example, we can see that moving from a flat salary to one where a portion of the compensation is contingent on a CDS spread adds a variable pay component that addresses shirking while explicitly making executives more risk averse.

How would this scheme look in practice? CEOs could be required to write a given amount of CDS (or to buy swaps written by other insurers) for the duration of their employment contract. However, a more efficient policy might use money set aside by the bank at the start of the period. Deferred bonuses would then be reduced or increased under a pre-specified formula as the bank’s CDS spread deviated from the average bank spread: bonuses would be increased if the spread was below average and decreased if it was above average. This approach has the added benefit of providing a built-in stabilizer. When banks are performing well and their credit quality is strong, bonuses will be paid out. However, when banks’ performance deteriorates and their credit quality weakens (leading to an increase in their CDS spread), they would be forced to conserve capital through the automatic reduction of bonuses. This approach is roughly analogous to automatically cutting dividends to protect the bank and its creditors. However, while cutting dividends imposes a cost on equity holders, this approach imposes a cost directly on risk takers.

Tying bonuses to a firm-level measurement such as a CDS spread (or a debt-like claim) motivates risk-taking employees to monitor each other to mitigate downside risk. CDS-based compensation may be particularly effective for risk avoidance because excessive risk taken by one employee can adversely affect all others, and thus linking compensation and risk is likely to shift the monitoring by outsiders to employees themselves.

Evidence That a CDS-Based Compensation Scheme Curbs Risk

Bolton, Mehran, and Shapiro’s study also provides evidence that increased CEO financial exposure to underlying bank risk does indeed reduce risk taking—an outcome that is reflected in lower CDS spreads. We exploit a change in SEC disclosure requirements in 2007 that provides greater detail on the deferred compensation and executive pension grant components of CEO pay. We then calculate the fraction of the executive’s pay that is at risk in the event of a bankruptcy. We find that the higher this fraction, the lower the bank’s CDS spread. Firms with higher-than-median investment in deferred compensation experience a reduction in their CDS spreads net of market movements that is 2.6 percent larger than that of firms below the median investment. This finding suggests that the market believes the theory laid out above: CEOs that stand to lose more financially in the event of their bank’s failure take lower risks.

Disclaimer
The views expressed in this blog are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York, or the Federal Reserve System. Any errors or omissions are the responsibility of the author.