Managerial Compensation, Regulation and Risk in Banks: Theory and Evidence from the Financial Crisis

This paper analyzes the relation between CEOs monetary incentives, financial regulation and risk in banks. We present a model where banks lend to opaque entrepreneurial projects to be monitored by managers; managers are remunerated according to a pay-for-performance scheme and their effort is unobservable to depositors and shareholders. Within a prudential regulatory framework that defines a capital requirement and a deposit insurance, we study the effect of increasing the variable component of managerial compensation on risk taking. We then test empirically how monetary incentives provided to CEOs in 2006 affected banks' stock price and volatility during the 2007-2008 financial crisis on a sample of large banks around the World. The cross-country dimension of our sample allows us to study the interaction between CEO incentives and financial regulation. The empirical analysis suggests that the sensitivity of CEOs equity portfolios to stock prices and volatility has been indeed related to worse performance in countries with explicit deposit insurance and weaker monitoring by shareholders. This evidence is coherent with the main prediction of the model, that is, the variable part of the managerial compensation, combined with weak insiders' monitoring, exacerbates the risk-shifting attitude by managers.