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Examining Risk-taking Incentives of Bank CEOs Prior to Financial Crisis

infozine.comFeb 27, 2012

Lawrence, KS - infoZine - In the wake of the financial crisis of 2008-09, public officials implemented policies to restrict and monitor the pay of the financial executives who “got us into this mess” with their “greed and excessive risk-taking.” Of course, these policies were based on the assumption that corporate risk-taking can be controlled by adjusting the incentives in executives’compensation contracts.

But is that assumption correct?

According to University of Kansas business professor Bob DeYoung, the answer appears to be yes. In an upcoming article, DeYoung demonstrates that contractual risk-taking incentives for CEOs at large U.S. banks increased around 2000 – when deregulation expanded banks’ growth opportunities – and that CEOs responded accordingly, especially at the larger banks best able to take advantage of these opportunities.

Additionally, DeYoung finds that when boards of directors at small- and medium-sized banks saw that risk levels had gotten too high, they responded by moderating their executives’ risk-taking incentives. But this didn’t happen at the largest banks with strong growth opportunities and a history of aggressive risk-taking incentives.

“If you’re going to argue for government intervention in CEO compensation as a way to temper risk-taking, you need to first demonstrate two things,” said DeYoung, the Capitol Federal Professor in Financial Markets and Institutions at KU. “First, that incentives in CEO pay contracts prior to the crisis led to increased risk-taking. And second, that bank boards of directors didn’t on their own make an effort to moderate excessive risk-taking by readjusting the incentives in executive pay packages. We found the first condition to be true for banks of all sizes and the second to be true for the largest U.S. commercial banks.”

DeYoung’s paper, “Executive Compensation and Business Policy Choices at U.S. Commercial Banks,” will be published in an upcoming 2012 issue of the Journal of Financial and Quantitative Analysis. The study is co-authored with two professors of accounting at Fordham University, Emma Peng and Meng Yan.

Historically, direct U.S. government interference in the compensation of private executives has been rare. But beginning in 2008-09, massive amounts of taxpayer assistance to large financial firms – for example, the Troubled Asset Relief Program; government bailouts of AIG, Fannie Mae and Freddie Mac; and loans, guarantees and other subsidies to facilitate private acquisitions of troubled banking firms – generated substantial popular support for government action to control or punish what President Barack Obama in 2009 referred to as the “recklessness and greed” of financial firm executives.

To frame the question of whether executive pay is influenced by contractual incentives, it’s useful to recall three related phenomena that converged during the mid- to late-2000s, with dire consequences for U.S. financial institutions. First, large commercial banks had transitioned from traditional “originate-and-hold” lending that relied on interest income and toward “originate-and-securitize” lending that relied on volatile fee income. Second, banks became increasingly reliant on mortgages to fuel their originate-and-securitize business and sold trillions of dollars of mortgage-backed securities (and/or derivatives) to institutional investors. And third, banks overweighted their portfolios with mortgage-backed securities as institutional investors underestimated the co-variances of housing prices across regions and financed these portfolios with large amounts of leverage. This approach generated record earnings during the 1990s and 2000s but allowed risk to accumulate on the balance sheets of banks and borrowers. Of course, this risk was exposed when the housing bubble collapsed.

“As we’ve now learned the hard way, it really was a house of cards,” DeYoung said.

So what fueled the move away from traditional bank practices and toward increased risk-taking? According to DeYoung, the increases appear to be related to changes in the regulatory and compensation environment. As DeYoung demonstrates, total compensation paid to CEOs at the largest U.S. commercial banks during the 1990s and 2000s differed little from the total compensation paid to CEOs at large U.S. industrial corporations. But the risk-taking incentives embedded in these compensation packages grew markedly different over time.

In fact, pay-risk sensitivity diverged permanently and substantially from non-bank CEOs around 2000, about the time that the Gramm-Leach-Bliley Financial Modernization Act of 1999 allowed banks to more fully compete in insurance underwriting, securities brokerage and investment banking – the last of which facilitated the expansion of their mortgage securitization activities.

“One plausible interpretation is that bank boards gave their CEOs the incentives necessary to exploit new growth opportunities in these product markets,” DeYoung said.

DeYoung’s conclusion that bank executives respond to contractual risk-taking incentives does not necessarily mean that government efforts to reduce risk-taking by shaping executive compensation would be effective.

“It’s also possible for banks to take less-than-desirable amounts of risk – for example, to make too few loans to support normal economic growth,” he said. “Overly aggressive compensation rules could lead to too much risk aversion by banks.”

DeYoung’s findings also indicate that bank CEOs were aware, to at least some extent, of the risks from non-traditional banking strategies, as evidenced by the self-moderation demonstrated by small- and medium-sized bank boards when actual risk-taking become too high.

“At the small- and mid-sized banks, the boards of directors scaled back CEO risk incentives when things got too hot,” DeYoung said. “But since this self-imposed moderation appears to be absent at the largest banks, banks with the strongest growth opportunities, and banks with histories of highly aggressive CEO risk-taking incentives, it would seem that intervention to restrict executive compensation would have the most social value if targeted on this subset of banks.”


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