CEO inside debt and risk-taking in US banks: evidence from three bank policies
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Date
01/07/2015Author
Srivastav, Abhishek
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Abstract
Widespread losses during the recent financial crisis have raised concerns that equitybased
CEO compensation (stocks and stock options) causes risky bank policies. This
has led to the need to understand whether CEO pay can be re-structured such that it
dampens risk-taking incentives. Against this background, this thesis analyses if debtbased
compensation (also known as inside debt and consisting of pension benefits
and deferred compensation) motivates CEOs to pursue risk-reducing bank policies.
Over three decades of research into executive compensation has not explored the
impact of inside debt, primarily due to lack of detailed data on inside debt which
only became available after 2006 in the United States (US). The paucity of empirical
work on inside debt is particularly unfortunate, given that the value of inside debt is
often substantial. This dissertation provides one of the first empirical investigations
into the impact of inside debt on bank risk-taking by determining whether CEO
inside debt leads to less risky behaviour, through three policy decisions that are
capable of increasing the overall risk of the bank.
First, this thesis focuses on the payout policies of banks. Bank payouts divert
cash to shareholders, while leaving behind riskier and less liquid assets to repay
creditors in the future. Payouts, thus, constitute a type of risk-taking that benefits
shareholders at the expense of creditors. The results presented in this thesis indicate
that higher inside debt results in more conservative bank payout policies.
Specifically, CEOs paid with more inside debt are more likely to cut payouts and to
cut payouts by a larger amount. Reductions in payouts occur through a decrease in
both dividends and repurchases. The results also hold over a sub-sample of banks
which received government support in the form of the Troubled Asset Relief
Program (TARP) where the link between risk-taking and payouts is of particular
relevance because it involves wealth transfers from the taxpayer to shareholders.
Second, this thesis tests the impact of inside debt on the risk implications of bank
acquisitions. Bank acquisitions are large scale investment decisions that can affect
bank risk. To this end, this thesis shows that higher inside debt holdings motivate
CEOs to pursue acquisitions that result in lower bank default risk. It also prevents
CEOs from using acquisitions to shift risk to the financial safety-net. Since the safety
net is underwritten by the taxpayer, the results show that CEO inside debt has a
measurable impact on the subsidy which bank shareholders obtain from taxpayers.
Third, the thesis shows that inside debt plays a critical role in influencing bank
capital holdings. Higher equity capital provides creditors with a larger loss-absorbing
equity buffer to protect the value of their claims on bank cash flows. Ceteris paribus,
higher equity protects creditors from losses. To this end, this thesis shows that higher
inside debt results in motivating banks to hold higher capital, whether defined using
regulatory or economic terms. Higher inside debt also results in reducing the
estimated value of the taxpayer losses. Furthermore, banks with higher inside debt
are at a lower risk of facing capital shortfalls. Taken together, the study provides insights on how incentives stemming from
inside debt impact bank policies in a manner that protects creditor interests. Inside
debt can help in addressing excessive risk-taking concerns by aligning the interests
of CEOs with those of creditors, regulators, and the taxpayer. This thesis makes a
novel contribution to the banking literature by providing evidence on the
implications of inside debt in the US banking industry. This work should be
interpreted as part of a wider body of research which demonstrates that inside debt
matters for bank risk-taking and that this role of inside debt should be recognized
more widely in ongoing discussions on compensation incentives in banking.