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University!of!Amsterdam!
Amsterdam!Business!School!
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MSc!Accountancy!and!Control;!Control!track!
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The!financial!crisis!and!its!effect!on!executive!compensation!and!
risk6taking:!a!study!of!financial!institutions!
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Stephanie!Jaimy!Losekoot*!
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*Student!number:!6047599!
Field:!Management!Accounting!
Supervisor:!Dr.!V.!O’Connell!
Date:!June!2014!
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ABSTRACT!
This!thesis!investigates!the!effect!of!executive!compensation!on!riskStaking!during!the! period! before! and! after! the! financial! crisis.! The! sample! consists! of! listed! financial! institutions! in! the! U.S.,! divided! into! depository! institutions,! insurance! companies! and! investment!companies.!The!different!components!of!executive!compensation!are!used,! which! are! base! salary,! annual! bonus,! stock! options,! and! common! stock.! We! measure! riskStaking! by! looking! at! the! zSscore! (i.e.$ default! risk)! and! stock! return! volatility.! The! results!show!that!base!salary,!common!stock!and!stock!options!have!a!positive!effect!on! riskStaking!in!the!period!before!the!financial!crisis,!while!base!salary!and!annual!bonus! decrease!riskStaking!after!the!crisis.!!Table!of!contents!
! I.!Introduction!!!!!!! 3!!
II.!Literature!review!and!hypotheses! 5! A.!Agency!theory! 5! B.!Executive!compensation! 7! B.1.!Evolution!of!executive!compensation! 7! B.2.!Executive!compensation!as!an!incentive!system! 9! B.2.1.!Executive!compensation!as!an!incentive!for!riskStaking! 10! B.3.!Executive!compensation!and!corporate!governance!structure! 12! B.4.!Executive!compensation!and!corporate!governance!in!financial!institutions! 13! C.!U.S.!regulations! 15! ! III.!Data! 17! A.!Sample! 17! B.!Variables! 19! B.1.!Dependent!variables! 19! B.2.!Independent!variables! 20! B.3.!Governance!score!(BSIndex)! 20! B.4.!Control!variables! 20! C.!Descriptive!statistics! 21! ! IV.!Research!methodology! 24! ! V.!Empirical!results! 25! A.!The!change!in!executive!compensation!structure! 26! B.!The!effect!of!executive!compensation!on!riskStaking! 26! C.!The!effect!of!executive!compensation!on!riskStaking!before!and!after!the!financial! crisis! 28! D.!The!effect!of!corporate!governance!on!executive!compensation!and!riskStaking! 29! ! VI.!Conclusion! 30! A.!Summary! 30! B.!Limitations!and!further!research!suggestions! 31! C.!Discussion! 32! ! References! 33! ! Appendix!A! 52! !I.!Introduction!
!Agency! theory! is! a! neoclassical! economic! theory! that! is! used! to! explain! the! principleS agent!problem.!It!explains!that!management!accounting!and!control!systems!can!be!used! in!order!to!monitor,!control!and!motivate!the!agent.!So!control!systems!can!be!seen!as! an!incentive!system!in!order!to!make!sure!that!the!agent!act!in!the!best!interest!of!the! principle! (Jensen! and! Meckling,! 1976).! Taking! this! into! account,! an! executive! compensation!package!can!be!seen!as!an!incentive!system!and!can!be!constructed!in!a! way! so! that! the! CEO! will! act! in! a! certain,! preferable,! way! (Jensen! and! Murphy,! 2004).! Here,!the!CEO!should!act!in!the!interest!of!the!shareholders,!which!means!that!executive! pay! should! be! closely! linked! to! firm! performance.! However,! prior! literature! finds! that! this! is! rarely! the! case! (Baker,! Jensen! and! Murphy,! 1988).! This! result! can! also! be! supported!by!the!recent!financial!crisis!and!suggests!that!executive!pay!is!indeed!weakly! tied! to! firm! performance.! Due! to! this,! executive! compensation! came! under! even! more! scrutiny! than! it! already! was.! It! is! argued! that! the! pay! arrangements! had! a! significant! effect! on! the! excessive! riskStaking! during! the! runSup! period! to! the! financial! crisis! and! were! designed! as! an! incentive! system! to! encourage! riskStaking! (Wall! Street! Journal,! 2009).! One! of! the! possible! explanations! for! the! CEO’s! excessive! riskStaking! is! that! remuneration!packages!were!more!focused!on!the!shortSterm!benefits!than!on!the!longS term!benefits!of!the!firm!by!granting!a!high!level!of!option!compensation!(Fahlenbrach! and!Stulz,!2010).!The!DoddSFrank!Wall!Street!Reform!and!Consumer!Protection!Act!(i.e.! DoddSFrank)!was!signed!by!President!Barack!Obama!on!July!21,!2010!and!is!one!of!the! laws! that! is! implemented! as! a! reaction! to! the! financial! crisis! and! executive! compensation! (Murphy,! 2012).! This! law! reforms! the! American! financial! regulatory! environment! and! affects! financial! regulatory! agencies! and! financial! services! firms.! It! promotes! financial! stability! by! increasing! accountability! and! transparency.! It! also! contains! some! executive! compensation! reforms! so! that! investors! have! more! influence! through! the! saySonSpay! for! firms! with! outstanding! funds! of! the! Troubled! Asset! Relief! Program! (TARP),! but! also! nonSTARP! companies! can! voluntarily! use! saySonSpay! votes! (SEC,!2011).!!
! Given! the! higher! level! of! scrutiny! on! the! remuneration! packages! of! CEOs,! the! financial! crisis! itself! and! the! acceptance! of! new! regulations! to! control! these! packages! and! riskStaking! behavior,! the! question! can! be! raised! whether! financial! institutions! changed!their!executive!pay!significantly!and!whether!this!had!an!effect!on!riskStaking.! The! purpose! of! this! research! is! to! investigate! this! and! we! address! the! following! question:!what!is!the!effect!of!the!financial!crisis!on!CEOs’!compensation!package!and!its!
riskStaking! behavior! in! financial! institutions?! Despite! the! fact! that! a! lot! of! research! is! already!done!on!executive!compensation,!this!thesis!differs!from!prior!papers!in!several! aspects.! First! of! all,! existing! literature! about! the! effect! of! executive! compensation! and! riskStaking!did!not!specifically!focus!on!the!periods!before!and!after!the!financial!crisis.! So!this!research!will!be!one!of!the!first!studies!that!specifically!focus!on!these!periods! and!compares!them.!Secondly,!there!is!almost!no!research!on!the!effect!of!regulation!on! executive! compensation! (Murphy,! 2012).! Existing! papers! only! focus! on! the! effect! of! a! particular! compensation! component! on! riskStaking! or! its! effect! on! firm! performance.! This! thesis! will! take! into! account! the! effect! of! regulation,! since! we! also! focus! on! the! period!after!the!crisis!in!which!new!important!laws!have!been!implemented.!Moreover,! this! thesis! addresses! financial! institutions! where! prior! literature! is! mainly! focused! on! industrial! firms! and! the! effect! of! compensation! on! riskStaking! (e.g.! Agrawal! and! Mandelker,! 1987;! DeFusco! et! al.,! 1990).! These! outcomes! cannot! necessarily! be! generalized! to! financial! institutions! whereas! the! executive! compensation! structure! differs! significantly! from! other! industries! (Houston! and! James,! 1995)! and! because! the! responsiveness!of!compensation!to!firm!performance!differs!among!regulated!and!nonS regulated!companies!(Smith!and!Watts,!1992).!This!thesis!also!has!a!social!contribution.! From! a! social! and! practical! point! of! view,! remuneration! committees! can! use! the! research! findings! in! practice.! They! can! use! the! results! as! a! guidance! how! to! eliminate! riskStaking!and!to!determine!what!executive!compensation!structure!is!more!common! today! in! financial! institutions.! Moreover,! this! research! can! be! of! concern! to! investors! and!potential!clients!who!are!interested!to!see!what!the!reaction!of!financial!institutions! is!to!the!new!regulations!that!have!been!implemented!after!the!financial!crisis!and!use! this!information!to!make!their!decisions.!!
! The!results!show!that!base!salary!and!stock!options!have!a!positive!effect!on!the! stock! return! volatility,! and! common! stock! will! decrease! the! zSscore! of! the! firm.! CashS based! compensation! will! decrease! riskStaking! while! marketSbased! compensation! increases! riskStaking.! We! see! that! only! base! salary! and! annual! bonus! have! a! different! influence! on! riskStaking! after! the! crisis.! These! pay! components! will! lower! the! overall! riskStaking! incentives! after! the! crisis,! whereas! the! marketSbased! components! have! no! significant!impact!on!riskStaking.!Common!stock!and!stock!options!have!a!positive!effect! on!riskStaking!in!the!period!before!the!crisis!and!after!the!crisis.!!
! The!remainder!of!this!thesis!is!as!follows:!section!II!will!first!discuss!the!relevant! literature! and! the! results! of! previous! studies! regarding! the! relationship! between! executive!compensation!and!riskStaking!and!thereafter!the!hypothesis!are!formed!based! on! this! information.! Section! III! will! go! into! detail! about! the! data! and! the! descriptive!
statistics.!Section!IV!elaborates!upon!research!methodology!in!which!the!used!model!is! developed.! The! empirical! results! will! be! reviewed! in! section! V.! Lastly,! section! VI! summarizes!the!findings!and!conclusions!of!this!research.!!!
II.!Literature!review!and!hypotheses! !
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In! this! section! relevant! literature! and! prior! findings! will! be! discussed,! which! will! be! used! to! define! the! hypotheses! for! this! research.! First,! agency! theory! will! be! analyzed.! Then!we!go!into!more!detail!about!executive!compensation!itself,!the!pay!structure!as!an! incentive! system! and! the! effect! of! corporate! governance! on! executive! compensation.! Moreover,!the!U.S.!regulations!will!be!discussed!and!lastly!prior!findings!regarding!the! relationship!between!executive!compensation!and!riskStaking!is!explored.!!! ! A.$Agency$theory$
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Business!organizations!changed!considerably!at!the!beginning!of!the!twentieth!century.! Mainly!due!to!the!soScalled!Great!Merger!Wave,!companies!have!grown!into!large!public! traded! enterprises! and! became! more! complex.! As! a! consequence,! executiveSmanaged! corporations! gradually! replaced! ownerSmanaged! or! familySmanaged! corporations,! where!“executives”!are!individuals!who!run!the!company!on!behalf!of!dispersed!ownerS shareholders!who!are!not!the!owner!of!the!firm!(Wells,!2010).!!!! The! separation! between! the! ownerSshareholders! and! the! executive! of! the! publicly! listed! company! resulted! in! a! new! problem,! called! the! agency! problem.! Jensen! and!Meckling!(1976)!explored!this!problem!in!detail!and!discuss!the!main!concept.!They! state!that!agency!theory!explains!the!conflict!that!will!arise!when!there!is!a!separation!of! ownership!and!control.!The!agency!relationship!is!a!contract!under!which!the!agent!(i.e.! executive)!will!act!on!behalf!of!the!principal!(i.e.!shareholders)!to!perform!some!service.! The! main! concern! here! is! whether! executives! are! using! their! control! to! enhance! shareholders’!wealth!or!their!own!wealth,!because!both!groups!are!utility!maximizers.! This!means!that!there!is!a!reason!to!believe!that!the!executive!will!not!always!act!in!the! interest!of!the!principal!and!will!enjoy!both!pecuniary!and!nonSpecuniary!benefits.!Also,! another!agency!problem!is!the!difference!in!risk!aversion!between!the!shareholder!and! the!executive!(Coffee,!1988).!Shareholders!can!easily!diversify!their!investments!at!low! costs!so!that!it!will!lower!their!overall!risk!exposure.!In!other!words,!shareholders!are! less! risk! averse.! However,! executives! cannot! diversify! by! selling! their! stocks! due! to!
federal! regulations! and! its! tight! connection! with! the! company.! So! an! executive! is! less! likely! to! take! risks,! whereas! he! holds! a! certain! amount! of! shares! for! a! specific! period! (Gray!and!Cannella!Jr.,!1997).!!
! There! are! two! main! versions! of! the! agency! problem:! the! agency! cost! of! equity! and! the! agency! cost! of! debt! (Jensen! and! Meckling,! 1976).! The! agency! cost! of! equity! explains!the!effect!of!equity!on!the!behavior!of!the!executive.!It!illustrates!that!it!is!more! likely! that! the! executive! will! engage! into! less! valuable! activities! when! he! only! owns! a! small! percentage! of! the! shares.! In! contrary,! the! executive! will! be! more! cautious! of! his! actions!when!he!owns!100%!of!the!shares!since!he!will!bear!the!full!risk!and!costs.!In! comparison,! agency! costs! will! be! generated! by! the! divergence! of! interest! between! the! executive!and!the!shareholders.!For!example,!if!an!executive!only!owns!8%!of!the!equity,! he!will!only!bear!a!fraction!of!the!costs!when!undertaking!activities.!So!an!executive!will! maximize! his! own! utility! while! not! incurring! the! full! amount! of! costs,! while! the! shareholders!will!bear!the!remaining!costs.!As!the!fraction!of!the!executive’s!equity!falls,! this!behavior!will!be!even!more!encouraged.!!!
! Murphy! (2012)! explains! the! agency! cost! of! debt! as! the! conflict! of! interest! between!the!shareholders!and!the!debt!holders.!Shareholders!prefer!risky!investments! by!executives,!while!debt!holders!do!not!want!that.!Agency!cost!of!debt!occurs!when!a! firm! is! more! likely! to! act! in! the! interest! of! the! shareholder! and! engages! into! risky! projects!with!a!high!return!but!a!low!success!rate.!When!the!investment!is!successful,! debt! holders! will! be! paid! off! while! the! remaining! profit! will! be! distributed! among! the! shareholders.! However,! the! debt! holders! will! bear! all! the! cost! when! the! investment! is! not!successful,!while!the!shareholders!bear!no!cost!at!all.!This!problem!is!mitigated!by! debt!covenants!and!constraints!that!place!restrictions!upon!how!the!borrowed!money! should!be!spent.!!
! So! how! can! you! encourage! the! executive! to! act! in! the! best! interest! of! the! shareholder?! Jensen! and! Meckling! (1976)! state! that! you! can! mitigate! this! problem! by! giving! executives! appropriate! incentives! or! by! monitoring! them! so! that! they! will! not! engage!in!aberrant!activities.!Sometimes!it!is!also!possible!to!set!up!some!costs!for!the! agent!when!he!takes!actions!that!will!harm!the!principal.!!However,!these!solutions!are! costly! and! a! firm! should! take! into! account! both! the! benefits! and! the! costs! of! these! mechanisms!in!order!to!make!a!decision!about!to!deal!with!the!agency!problem.!Also,! despite!these!solutions,!the!firm!is!not!able!to!fully!align!the!interest!of!the!agent!with! the!interest!of!the!principal.!The!remaining!divergence!between!the!two!actors!is!also!a! cost!and!is!called!the!residual!loss.!Overall,!the!total!agency!costs!can!be!defined!as!the!
sum! of! the! monitoring! costs! by! the! principal,! the! bonding! costs! by! the! agent! (e.g.! providing!incentives)!and!the!residual!loss.!!!!
! Jensen!(1993)!also!states!that!there!are!four!main!mechanisms!that!could!reduce! this! agency! problem.! These! are! the! use! of! a! board! of! directors,! capital! markets! (e.g.! blockholders),!regulatory!system!and!product!markets!(e.g.!competition).!However,!it!is! still!not!clear!how!to!use!these!mechanisms!optimally!to!prevent!agency!problems.! ! B.$Executive$compensation$ B.1.$Evolution$of$executive$compensation$
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An! executive! compensation! package! usually! consists! of! a! fixed! component! and! a! performance!contingent!component!(Gray!and!Canella!Jr.,!1997).!The!fixed!component,! or! base! salary,! protects! the! executive! from! uncontrollable! events! that! could! have! an! effect! on! the! performance! of! the! company.! The! performance! contingent! component! is! more!risky!for!the!executive!whereas!this!pay!depends!directly!on!the!firm’s!outcomes.! This! payment! can! be! divided! into! shortSterm! incentives,! which! is! mostly! a! nonSequity! annual! bonus,! and! longSterm! incentives,! which! are! mostly! equity! based! payment! as! restricted! stock! or! options! (Murphy,! 2012).! Restricted! stock! implies! that! the! stock! is! granted,!but!only!can!be!traded!after!a!specific!period!of!time!and!stock!options!provide! the!executive!the!right!to!buy!shares!at!a!preSspecified!price!in!the!future.!Besides!these! main!types!of!compensation,!there!are!also!other!forms!of!compensation!(e.g.!pension,! nonSqualified!deferred!compensation,!and!a!car).! ! Figure!1!(Murphy,!2012)!shows!the!evolution!of!the!different!components!and! total!amount!of!executive!pay!from!1992!to!2011!for!CEOs!in!S&P!500!firms.!The!figure! shows!that!the!total!level!of!compensation!grew!significantly!from!1992!to!2001,!with!an! overall!record!of!$9.3!million!in!2001.!The!proportion!of!base!salary!as!a!percentage!of! total!compensation!remained!approximately!on!the!same!level!over!the!years,!while!the! cash! bonuses! started! to! grow.! However,! these! two! components! represent! a! lower! percentage!of!total!compensation!over!the!years!whereas!stock!options!and!restricted! stock! started! to! get! more! popular.! In! particular,! the! use! of! stock! optionSbased! compensation! grew! from! 1993! to! 2001,! but! was! less! popular! in! the! period! 2002! to! 2011.! Hall! and! Liebman! (1998)! also! confirmed! this! and! state! that! in! 1980! the! compensation! was! mainly! based! on! cash! and! bonuses! while! by! 1994! option! compensation!had!become!a!significant!part!of!total!compensation!(e.g.!option!grants!of! approximately! $1.2! million! compared! with! $1.3! million! in! cash! pay).! Also,! the! overall!
percentage!of!CEOs!that!holds!some!amount!of!options!increased!from!57%!in!1980!to! almost!90%!in!1994.!Core!and!Guay!(2001)!also!mention!the!difference!in!stock!option! grants! among! industries.! They! find! that! growth! industries! (e.g.! pharmaceutical! firms)! grant!more!stock!options!than!low!growth!industries.!!
! Next,! we! focus! particular! on! the! period! of! the! financial! crisis! (i.e.! 2004S2011).! We!can!see!that!total!compensation!grew!from!$8.1!million!to!$9.1!million!in!the!run!up! period! to! the! crisis,! while! there! is! a! significant! drop! during! the! crisis! itself! with! a! minimum! of! $7.4! million.! The! total! compensation! after! the! crisis! grew! again! to! an! amount!of!$8.8!million!in!2010!and!$9.0!million!in!2011.!This!should!suggest!that!the! financial!crisis!had!no!impact!on!total!compensation.!However,!we!can!see!that!the!level! of!stock!options!did!go!down!after!the!crisis!and!the!amount!of!restricted!stock!grew.!So! the!overall!compensation!structure!changed.!! ! Figure!1.!Executive!compensation!in!S&P!500!Firms!from!199262011!(Murphy,!2012)! ! ! ! Bushman!and!Smith!(2003)!state!that!compensation!packages!also!differ!among! countries!due!to!countrySspecific!factors,!such!as!shareholder!protection.!In!contrast!to! shareholders! in! the! U.S.,! are! European! shareholders! not! as! well! protected.! Widely! dispersed!ownership!is!therefore!not!very!suitable!and!common!in!these!countries.!Most! firms! are! familySowned! businesses! or! managers! own! a! large! share! of! the! company.! EquitySbased! compensation! is! therefore! unnecessary.! However,! equitySbased! compensation!is!heavily!used!in!the!U.S.!to!align!the!interests!of!the!executive!and!the! shareholders.!!
! Given! the! information! on! the! evolution! of! executive! pay,! the! following! hypotheses!are!defined!
Hypothesis* 1:! total! executive! pay! was! higher! in! the! period! before! the! financial! crisis! than!in!the!period!after!the!financial!crisis! ! Hypothesis*2:! less!stockSoption!based!compensation!is!granted!in!the!period!after!the! financial!crisis!than!in!the!period!before!the!crisis! ! Hypothesis*3:*more!common!stock!is!granted!in!the!period!after!the!financial!crisis!than! in!the!period!before!the!crisis! ! B.2.$Executive$compensation$as$an$incentive$system$$
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In!this!research!we!will!focus!on!how!to!limit!the!agency!problem!by!providing!the!right! incentives,!so!constructing!the!most!appropriate!compensation!package!for!the!CEO.!The! main!goal!is!to!compose!the!most!efficient!contract,!which!is!defined!as!a!contract!that! minimizes! agency! costs! (Core,! Guay! and! Larcker,! 2003).! However,! it! should! be! noted! that!optimal!contracts!evolve!with!internal!and!external!changes!over!time.!An!efficient! contract! today! is! most! probably! not! efficient! anymore! after! ten! years.! Firms! are! therefore!experimenting!over!time!to!find!their!efficient!contract.!However,!during!the! periods! of! finding! their! efficient! contract,! the! executive! is! able! to! extract! rents! due! to! gained!power!and!can!exploit!shareholders!(Core,!Guay!and!Larcker,!2003).!Despite!this! limitation,!we!assume!that!compensation!contracts!are,!on!average,!efficient.!!! !You! have! to! meet! two! criteria! in! order! to! compose! an! optimal! compensation! package:! (1)! you! must! be! able! to! measure! the! appropriate! performance! measure! accurately;! and! (2)! you! should! attach! the! right! compensation! to! this! performance! (Murphy,!2012).!Also,!the!paySforSperformance!sensitivity!has!to!be!determined,!where! a!higher!sensitivity!implies!having!better!incentives.!Moreover,!the!executive!must!know! how!it!can!influence!the!performance!measure.!For!example,!the!executive!knows!how! to! increase! income! (i.e.! increase! sales,! lower! the! costs),! but! it! is! more! difficult! to! determine!what!actions!should!be!taken!to!increase!the!stock!price!(Murphy,!2012).!! ! This! example! shows! that! the! different! components! of! the! executive! compensation!package!impose!different!amounts!of!risk!on!the!executive.!Base!salaries! will!impose!the!least!risk!on!the!executive!while!restricted!stock!and!stock!options!are! the! most! risky! form! of! compensation! (Murphy,! 2012).! Base! salaries! are! not! risky! because!the!executive!will!receive!a!fixed!payment!regardless!his!performance!over!the! year.!On!the!other!hand,!the!value!of!restricted!stock!and!stock!options!depends!on!the!
firm!value!and!stock!price!respectively,!so!they!provide!an!incentive!for!the!executive!to! improve! the! overall! firm! performance.! These! compensation! components! however! impose!risk!on!the!executive,!because!the!stock!price!is!easily!influenced!by!factors!that! are! beyond! the! executive’s! control.! This! means! that! the! stock! price! as! a! performance! measure!is!a!noisy!measure!and!executives!have!to!be!compensated!for!this!by!receiving! a!premium!(e.g.!an!increase!in!base!salary)!(Core,!Guay!and!Larcker,!2003).!
! So!far!we!know!that!compensation!packages!should!provide!the!right!incentives,! but! what! are! the! right! incentives?! This! depends! on! the! objectives! of! the! company.! A! manufacturing! firm! for! example! may! want! to! reduce! costs,! and! as! a! reaction! to! this,! executive! compensation! will! be! constructed! with! these! incentives.! However,! the! main! goal! of! all! the! firms! is! to! increase! their! overall! value.! This! means! that! the! CEO! should! focus!on!increasing!shareholder!value.!The!agency!cost!of!equity!explains!that!executive! compensation!can!be!used!to!influence!the!behavior!of!the!executive!and!let!him!act!in! the!best!interest!of!the!shareholders.!Specifically,!equitySbased!compensation!is!used!to! increase!firm!value!and!stock!price.!Ittner!et!al.!(2001)!also!indicates!that!the!primary! reason!for!granting!stock!options!is!to!retain!employees.!Oyer!and!Schaefer!(2001)!on! the!other!hand!find!that!stock!options!are!granted!in!order!to!attract!less!risk!averse!and! optimistic! employees.! So! equity! based! compensation! can! also! be! used! to! attract! and! retain!employees.!However,!stock!options!can!also!provide!an!incentive!for!the!CEO!to! postpone! or! reduce! dividends! payments! when! he! wants! to! exercise! their! options,! because!it!will!otherwise!decrease!the!stock!price!(Core,!Guay!and!Larcker,!2003).!! !! ! ! B.2.1.$Executive$compensation$as$an$incentive$for$risk<taking$
!
The!compensation!package!will!have!a!different!influence!on!the!riskStaking!behavior!of! the!executive.!More!risk!is!taken!when!the!executive!is!only!rewarded!for!upside!risk!but! is!not!punished!for!downside!risk!(Murphy,!2012).!This!is!especially!the!case!with!stock! options,! whereas! the! executive! will! only! benefit! when! the! stock! price! exceeds! the! exercise!price,!but!the!executive!will!not!be!harmed!when!the!stock!price!falls!below!the! exercise!price.!!This!example!shows!that!the!pay!for!performance!relationship!is!convex.! So! the! executive! will! engage! into! more! risky! projects! in! order! to! make! sure! that! the! stock! price! will! go! up.! The! same! is! true! for! the! annual! bonus! of! the! CEO! which! encourages! more! shortSterm! thinking.! The! CEO! will! take! on! more! risky! shortSterm! projects!in!order!to!reach!their!target,!because!they!know!that,!besides!not!getting!their! bonus,! they! will! not! be! punished! when! they! do! not! reach! their! target.! The! contrary! is!true!for!common!stock,!because!the!CEO!does!suffer!when!the!stock!price!goes!down.!So! the!CEO!is!less!likely!to!take!more!risk.!Lastly,!riskSaverse!executives!prefer!fixed!base! salary!to!variable!pay!(Murphy,!1998).!So!CEOs!with!a!higher!percentage!of!fixed!salary! to!total!compensation!are!less!likely!to!engage!in!risky!investments.!!
! Murphy! and! Jensen! (2011)! argue! that! the! board! of! directors! purposely! makes! executive!pay!more!convex!to!encourage!riskStaking.!Also,!compensation!package!must! align!with!the!risk!aversion!and!diversification!possibilities!of!the!executive,!which!again! has!an!influence!on!the!riskStaking!behavior!of!the!executive.!Most!executives!are!risk! averse! and! undiversified,! so! they! are! more! conservative! in! taking! risks.! When! determining! the! optimal! riskStaking! zone! for! the! firm,! it! has! to! be! noted! that! a! riskS return!tradeoff!has!to!be!made,!whereas!a!higher!return!is!received!when!more!risk!is! taken.! Within! this! riskStaking! zone,! the! firm! just! incurs! enough! of! risk! to! pursue! their! goals! and! increase! firm! value! (COSO,! 2012).! So! compensation! packages! need! to! be! structured!so!that!it!provides!the!right!incentives!for!the!CEO!to!take!the!most!optimal! risk.!!
! Building! on! the! previous! discussion,! we! argue! that! executive! compensation! components!do!have!an!effect!on!riskStaking.!This!leads!to!the!following!hypotheses! ! Hypothesis*4:*stockSoption!based!compensation!has!a!positive!effect!on!riskStaking! ! Hypothesis*5:*bonus!compensation!has!a!positive!effect!on!riskStaking! ! Hypothesis*6:*restricted!stock!has!a!negative!effect!on!riskStaking! ! Hypothesis*7:*base!salary!has!a!negative!effect!on!riskStaking! !
! Few! papers! have! investigated! the! specific! relationship! between! executive! compensation! and! riskStaking! before! and! after! the! financial! crisis.! More! specifically,! existing! studies! focus! on! the! change! in! compensation! structure! within! a! specific! time! period! and! its! effect! on! riskStaking! in! financial! institutions.! A! few! papers! investigated! the! effect! of! a! specific! component! of! the! CEO’s! pay! on! riskStaking! in! banks! (e.g.! Chen,! Steiner!and!Whyte,!2006)!while!most!studies!address!the!sensitivity!of!CEO!pay!to!bank! performance!(e.g.!Fahlenbrach!and!Stulz,!2010).!!
! The! paper! of! Fahlenbrach! and! Stulz! (2010)! investigated! whether! executive! compensation!before!the!crisis!had!a!significant!effect!on!bank!performance!during!the! financial! crisis.! They! find! that! banks! with! compensation! packages! that! were! better!
aligned! with! shareholder! interests! performed! worse! during! the! crisis.! However,! they! find! the! contrary! for! banks! with! higher! stock! option! compensation! and! a! higher! percentage!of!cash!bonuses.!Moreover,!they!find!that!stock!option!payments!did!not!lead! to! excessive! riskStaking.! Houston! and! James! (1995)! is! an! example! of! a! research! that! looks! at! the! effect! of! CEO! pay! on! riskStaking.! They! did! not! specifically! look! at! the! financial!crisis!but!researched!whether!Bank!CEO!packages!were!designed!to!promote! riskStaking.! Similar! to! the! research! of! Fahlenbrach! and! Stulz! (2010),! they! did! not! find! that! equitySbased! compensation! induced! more! riskStaking.! Also,! they! did! find! that! the! compensation! packages! of! banks! differed! significantly! from! nonSbanks.! Chen,! Steiner! and! Whyte! (2006)! investigated! whether! optionSbased! compensation! had! a! significant! effect! on! riskStaking,! focusing! specifically! on! the! banking! sector.! They! find! that,! following! deregulation,! the! banking! sector! used! more! optionSbased! compensation! during! the! period! from! 1992! until! 2000! and! that! this! change! led! to! more! riskStaking.! This!result!is!not!in!line!with!the!results!of!Fahlenbrach!and!Stulz!(2010)!and!Houston! and!James!(1995).!John!et!al.!(2000)!conducted!a!different!sort!of!study!and!argue!that! executive! compensation! has! more! effect! on! the! riskStaking! behavior! of! managers! in! banks! than! regulations! do.! This! is! one! of! the! few! papers! that! makes! a! comparison! between!the!effect!of!executive!pay!and!regulations!on!a!firm’s!its!riskStaking.!!
!
B.3.$Executive$compensation$and$corporate$governance$structure$
!
The!board!of!directors!is!also!used!as!a!mechanism!to!control!the!behavior!of!the!CEO.! The! members! of! the! compensation! committee! determine! executive! pay! and! can! therefore! influence! the! actions! of! the! executive.! However,! more! critics! argue! that! a! board! of! directors! is! not! effective.! Core,! Holthausen! and! Larcker! (1999)! say! that! the! board! of! directors! is! highly! influenced! by! the! CEO,! which! lead! to! the! fact! that! the! compensation!package!is!ultimately!structured!to!maximize!the!value!for!the!CEO!and! not! the! value! for! outside! shareholders.! Jensen! (1993)! also! mentions! some! arguments! why!the!CEO!has!such!an!influence.!First!of!all,!the!board!culture!discourages!conflicts.! So!even!if!the!board!does!not!agree!with!a!specific!action!the!CEO!wants!to!undertake,! they!will!eventually!concede.!Also,!the!CEO!determines!the!agenda!of!the!board!and!is! most!of!the!time!also!the!chairman!of!the!board.!Crystal!(1991)!also!states!that!the!CEO! has! the! power! to! both! hire! and! fire! outside! directors.! So! it! is! less! likely! that! outside! directors! will! interfere! with! the! actions! of! the! CEO,! in! order! to! secure! their! position! within! the! board.! These! findings! suggest! that! a! weak! corporate! governance! structure!
has! a! negative! effect! on! the! effectiveness! of! the! compensation! package.! Here,! the! definition!of!a!weak!governance!structure!is!when!board!members!are!not!independent! and!the!CEO!has!too!much!power!to!influence!his!own!pay.!!
! Core,!Holthausen!and!Larcker!!(1999)!did!a!study!on!the!effect!of!the!quality!of! firms’! corporate! governance! on! the! compensation! of! the! CEO! and! also! find! that! weak! governance! structures! has! a! positive! effect! on! the! CEOs’! pay.! They! mention! that! an! ineffective! governance! structure! leads! to! greater! agency! problems,! with! as! a! result! greater!CEO!compensation.!Specifically!they!find!that!CEO!compensation!is!higher!when! the!CEO!is!the!chairman!of!the!board,!the!board!consists!of!more!members,!and!when! there!are!more!outside!directors!and!the!CEO!hires!them.!Moreover,!Mehran!(1995)!find! that! CEOs! earn! more! equitySbased! compensation! when! there! is! a! stronger! board! (i.e.$ more!outside!directors).!!
! Given!the!literature!and!prior!finding,!the!following!hypothesis!is!defined! !
Hypothesis* 8:! stronger! governance! structures! lead! to! less! total! compensation,! which! again!results!in!less!riskStaking!
! !!
B.4.$Executive$compensation$and$corporate$governance$in$financial$institutions$
!
The!majority!of!prior!studies!focus!on!the!relationship!between!corporate!governance! and! executive! compensation! in! nonSfinancial! industries,! while! this! thesis! focuses! specifically! on! listed! financial! institutions.! Literature! showed! that! the! corporate! governance!structure!does!differ!significantly!among!industries,!and!especially!between! nonSfinancial!and!financial!firms!(Adams!and!Mehran,!2003).!This!fact!is!also!supported! by!the!contingency!theory!that!explains!there!is!no!uniformly!governance!structure!for! all! industries,! whereas! you! have! to! take! into! account! the! industries! differences.! A! uniformly!governance!system!will!be!ineffective!or!worse,!could!harm!the!firm.!! ! Adams!and!Mehran!(2003)!stated!three!factors!that!could!have!an!effect!on!the! governance!structure.!First!of!all,!financial!institutions!are!complex!and!are!dependent! on!the!trust!of!the!client!in!order!to!operate.!Clients!must!have!the!confidence!that!their! money!will!be!in!good!hands.!If!clients!lose!their!trust,!it!can!prove!detrimental!for!the! firm.!Moreover,!many!different!stakeholders!have!an!interest!in!the!performance!of!the! company.! Especially,! the! local! government! and! regulators! are! concerned! whereas! the! overall! economy! may! be! affected! when! a! big! financial! institutions! is! not! performing! well.!Lastly,!the!financial!institution!sector!is!heavily!regulated!which!has!a!significant!
effect!on!the!corporate!governance!structure.!They!have!to!abide!the!law!and!the!many! regulations,! which! ensure! that! the! financial! institutions! are! more! responsible! and! transparent! about! their! actions.! Also,! Berger,! et! al.! (1995)! mention! that! financial! institutions! maintain! a! higher! amount! of! leverage,! which! result! in! increasing! financial! distress!costs.!Due!to!this,!the!board!structure!could!be!different!because!it!is!most!likely! that!the!board!wants!more!financial!experts.!!
! There! is! also! a! difference! in! executive! compensation! between! financial! institutions! and! nonSfinancial! institutions.! (Adams! and! Mehran,! 2003).! First! of! all,! regulations!and!laws!have!a!significant!effect!on!the!compensation!structure.!Regulatory! reform! on! executive! compensation! has! been! expanded! over! recent! years! and! focused! specifically!on!the!potential!incentives!of!the!pay!structure.!We!will!discuss!this!in!more! detail! later.! Secondly,! the! investment! opportunities! within! an! industry! influences! compensation.!We!argue!that,!because!it!is!easier!to!monitor!and!evaluate!the!actions!of! CEOs!in!firms!in!lowSgrowth!industries,!the!CEO!receives!less!stock!based!compensation! (Smith!and!Watts,!1992).!Campbell,!et!al.!(2001)!find!that!banking!industry!volatility!is! significantly!smaller!than!the!manufacturing!industry!volatility,!so!financial!institutions! are!less!likely!to!grant!stockSbased!payments!than!nonSfinancial!institutions.!Moreover,! executive! compensation! is! also! affected! by! the! competition! within! an! industry! (Fama,! 1980).!StockSbased!compensation!will!be!more!used!in!industry!were!there!is!almost!no! competition,!since!they!cannot!use!relative!performance!as!a!control!system.!However,! relative!performance!is!more!used!in!highly!competitive!sectors!whereas!it!is!a!precise! measure! and! the! performance! of! the! CEO! is! easier! to! identify.! So! since! the! financial! industry!is!highly!competitive,!stock!based!compensation!will!be!less!important.!Lastly,! the! capital! structure! may! affect! compensation.! Stock! options! will! motivate! the! CEO! to! pursue!riskier!projects,!which!is!supported!by!the!shareholders!but!not!the!debt!holders! who!will!bear!all!the!costs.!Debt!holders!want!to!be!compensated!for!this!risk!and!the! cost!of!debt!will!be!higher!(John!and!John,!1993).!So!firms!with!a!higher!leverage!ratio! will! have! a! much! higher! cost! of! debt.! Since! financial! institutions! are! highly! leveraged,! they!may!want!to!limit!the!use!of!stock!options.!!
!!! The! work! of! Adams! and! Mehran! (2003)! did! find! a! significant! difference! in! the! corporate! governance! structure! and! executive! compensation! between! manufacturing! firms! and! banks.! They! find! that! the! overall! board! was! bigger! and! there! were! more! outside! board! members! in! banks.! Moreover,! banks! had! more! different! committees,! which! also! had! more! meetings.! Regarding! the! compensation! structure,! banks! granted! less! stock! options! than! manufacturing! firms.! These! results! show! that! the! governance!
structure!might!indeed!be!different!between!financial!institutions!and!other!industries.!
! !
C.$U.S.$regulations!
!
In! this! section! the! most! important! implemented! regulations! and! laws! in! the! US! are! discussed!and!also!their!effect!on!executive!pay.!However,!the!reader!should!take!into! account! that! also! more! subtle! changes! has! been! taken! place! which! we! do! not! address! here!(e.g.!tax!policies,!listing!and!disclosure!requirements,!accounting!rules).!!!
! Murphy! (2012)! mention! that! the! political! climate,! regulations,! legislation,! tax! policies! and! disclosure! requirements! have! a! significant! effect! on! the! composition! of! executive! pay! and! causes! a! change! in! the! composition! over! time.! So! government! intervention! plays! a! crucial! role! in! the! overall! structure! of! executive! compensation,! which!again!is!also!influenced!by!the!critique!and!opinions!of!different!parties!regarding! pay!practices.!!
! For!nearly!a!century!there!has!been!a!controversy!over!executive!pay,!especially! on!the!level!of!pay!and!the!weak!correlation!between!pay!and!performance.!Brownstein! and! Panner! (1992)! emphasized! that! CEOs! earn! approximately! 130! times! the! salary! of! the! lowest! paid! employee,! and! this! gap! is! still! increasing.! Moreover,! there! are! studies! that!show!that!compensation!levels!are!marginally!related!to!performance!(e.g.!Yablon,! 1992).!An!explanation!for!the!high!pay!levels!can!be!based!on!signaling.!A!firm!wants!to! be!recognized!as!a!powerful!company!with!a!strong!governance!structure,!which!means! that!no!firm!wants!to!confess!that!their!CEO!is!below!average.!So!the!pay!level!can!be! seen! as! a! signal! that! the! CEO! is! above! average! and! that! he! is! very! skilled! (Hayes! and! Schaefer,! 2009).! This! benchmarking! leads! to! increasing! compensation! levels! and! different!parties!advocate!for!regulation!and!reform.!!
! Since!1932!the!first!major!step!was!taken!into!executive!pay!regulations.!Since! then! it! was! obligatory! to! disclose! information! regarding! executive! compensation! in! bailedSout! railroads,! which! soon! also! expanded! to! public! listed! companies! (Murphy,! 2012).!After!this,!the!government!enacted!Section!162(m)!in!the!early!1990s!that!consist! of! rules! on! tax! deductibility! in! order! to! reduce! CEO! pay! in! public! listed! companies.! President! Clinton! thought! that! compensation! levels! above! $1! million! were! unreasonable,! so! disallowed! firms! to! deduct! their! compensation! when! it! is! above! this! level.!Nevertheless,!CEO!pay!increased!significantly.!First!of!all,!this!rule!did!not!apply! for!performanceSbased!stock!option!compensation,!so!Section!162(m)!was!an!incentive! to!grant!more!stock!options.!Second,!firms!that!paid!salaries!below!$1!million!raised!the!
pay! to! exactly! $1! million.! Lastly,! most! of! the! firms! adjusted! their! bonus! plans! with! generous!formulas!(Murphy,!2012).!! ! In!July!2002!the!SarbanesSOxley!Act!has!been!implemented!as!a!reaction!to!the! many!accounting!scandals!that!had!erupted!across!the!U.S.!This!act!was!mainly!focused! on!correcting!accounting!irregularities!and!not!so!much!on!executive!pay.!Nevertheless! is!this!law!used!as!a!way!to!regulate!pay.!It!forbid!offering!loans!to!executives,!CEOs!and! CFOs!have!to!reimburse!their!bonuses!and!other!incentives!when!the!company!needs!to! revise! its! financial! statements! due! to! misconduct! (this! law! is! extended! in! the! TARP! legislation! and! the! DoddSFrank! Act)! and! firms! had! to! disclose! new! grants! of! options! within! two! business! days.! The! last! regulation! was! a! good! solution! to! restrain! option! backdating!(Murphy,!2012).!!
! However,!executive!compensation!started!to!change!significantly!during!the!first! thirteen!years!of!the!twentieth!first!century!in!large!US!companies.!!First!of!all,!there!was! a!stock!market!crash!in!the!early!2000s!due!to!the!bursting!of!the!Internet!Bubble!and!as! a! consequence,! the! use! of! stock! options! dropped! significantly! and! restricted! stock! became! more! popular.! Secondly,! financial! service! firms! (i.e.! namely! banks)! that! are! receiving! assistance! under! the! Treasury’s! Troubled! Asset! Relief! Program! (TARP)! are! under!special!pay!restrictions.!(Murphy,!2012).!!
! Lastly,! the! DoddSFrank! executive! Compensation! Act,! which! has! been! signed! in! 2010,! tries! to! regulate! executive! compensation! specifically! in! financial! service! firms.! This!act!goes!much!further!than!the!pay!restrictions!under!the!TARP!recipients,!whereas! this!act!focuses!on!all!financial!institutions.!The!DoddSFrank!act!also!controls!riskStaking! behavior! of! the! executive! by! prohibiting! compensation! packages! that! encourage! exceptional! risk.! Excessive! compensation! and! pay! packages! that! could! have! negative! effect!on!the!performance!of!the!financial!institution!are!therefore!not!allowed.!This!has! been! implemented! as! a! reaction! the! critics! who! argue! that! executive! pay! in! financial! institutions! led! to! excessive! riskStaking! that! in! turn! contributed! to! the! financial! crisis.! They!state!that!the!compensation!structure!was!too!much!convex,!whereas!the!executive! only! benefits! from! the! upside! potential! and! has! no! downside! risk! (Murphy,! 2012).! Executives!were!encouraged!to!take!excessive!risk!that!could!harm!the!firm!by!receiving! stock!options!as!compensation.!Also,!executive!compensation!was!more!focused!on!the! shortSterm! performance! than! on! the! longSterm! performance! (Fahlenbrach! and! Stulz,! 2010).!
! There! are! several! important! rules! regarding! executive! pay! that! are! part! of! the! DoddSFrank! Act.! First! of! all,! under! the! SaySonSPay! the! shareholders! are! asked! to! give! their!approval!for!the!executive’s!compensation!at!least!every!three!years.!This!is!a!way!
to!involve!the!shareholders!in!the!design!of!pay!and!to!increase!the!transparency!of!the! compensation! practices.! Secondly,! the! clawback! rule! of! the! SarbanesSOxley! act! is! extended,!whereas!firms!have!to!report!the!policies!for!recouping!payments!when!the! financial! statement! has! been! restated.! Thirdly,! financial! institutions! have! to! add! additional! disclosures! (e.g.! disclose! policies! on! hedging! by! employees)! and! also! the! compensation! committee! has! to! be! independent.! Lastly,! certain! shareholders! are! allowed! to! nominate! their! own! director! candidates! in! the! annual! proxy! statement! besides!the!board’s!nominees!(Murphy,!2012).!
! The! DoddSFrank! act! was! a! reaction! to! the! financial! crisis! and! tries! to! regulate! executive! compensation! drastically.! It! tries! to! increase! the! financial! institutions’! transparency!in!the!executive!compensation!structure!and!involve!shareholder!more!in! the!process.!It!can!be!said!that!the!corporate!governance!structure!has!to!change!as!a! reaction!to!this!new!law,!and!also!the!pay!structure.! ! This!discussion!leads!to!Hypothesis!9,!which!is!defined!as!follow! ! Hypothesis*9:!more!risk!is!taken!by!the!CEO!in!the!period!before!the!financial!crisis!than! in!the!period!after!the!financial!crisis.!!
!
II.!Data
! !This! section! introduces! the! used! data! for! this! research.! First,! the! sample! will! be! discussed.!Secondly,!the!definitions!of!the!dependent,!independent!and!control!variables! are! presented! in! turn.! Lastly,! the! descriptive! statistics! will! be! analyzed.! Appendix! A1! shows!the!full!list!and!definitions!of!the!variables.!! ! A.$Sample$
!
The!sample!consists!of!228!different!financial!institutions!in!the!United!States.!We!will! focus!specifically!on!the!U.S.!due!to!the!fact!that!the!crisis!initially!started!in!this!country! and! involved! and! affected! many! financial! institutions! (Dullien,! et! al.,! 2010).! There! are! also!different!legislations!that!have!been!implemented!in!the!U.S.!after!the!crisis!(e.g.!the! DoddSFrank!act!and!the!executive!compensation!restrictions!under!TARP),!which!had!a! significant!effect!on!the!composition!of!the!executive!compensation!package.!Therefore,! financial!institutions!in!the!U.S.!are!affected!the!most!by!these!events!which!can!lead!to! more!clear!results.!!! The! sample! only! consists! of! listed! financial! institutions,! whereas! information! regarding! stock! prices! and! returns! is! needed! to! calculate! a! marketSbased! riskStaking! variable.! Also,! the! information! is! more! easily! accessible! when! focusing! on! listed! firms! and! inclusion! of! smaller! institutions! could! lead! to! biased! results! (e.g.! probability! of! significant! lower! salaries! in! nonSlisted! firms! compared! to! listed! financial! institutions).! ! This!research!will!focus!on!the!three!main!groups!of!financial!institutions,!which! are!the!depository!institutions,!insurance!companies!and!investment!institutions.!These! are!represented!by!the!SIC!codes!602!to!603,!631!to!636,!and!620!to!628,!respectively! (United!States!Department!of!Labor,!n.d.).!Depository!institutions!are!commercial!banks! and!savings!banks!and!investment!institutions!are!mainly!investment!banks,!brokerage! firms! and! investment! advisory! firms.! There! are! in! total! 228! firms,! consisting! of! 112! depository! institutions,! 39! investment! institutions! and! 77! insurance! companies.! See! table!1!for!the!list!of!financial!institutions.!!
! The!data!is!unbalanced!panel!data!gathered!from!databases.!CEO!compensation! data!is!obtained!from!Execucomp.!This!database!will!give!access!to!information!on!the! different!components!of!executive!pay!of!top!officers!for!the!S&P!1500.!Also,!the!Center! for!Research!in!Security!Prices!(CRSP)!will!be!used!to!get!the!stock!prices.!This!data!will! be! used! to! calculate! the! stock! return! volatility! as! risk! measure.! Moreover,! Compustat! will!be!used!to!as!a!source!to!gather!firm’s!accounting!data,!which!are!going!to!be!used! for!calculating!the!zSscore!and!as!control!variables.!Also,!the!monthly!return!of!the!S&P! 1500!financial!sector!index!is!calculated!using!the!monthly!index!prices!of!Compustat.! Lastly,!RiskMetrics!will!be!used!to!gather!data!on!the!corporate!governance!structure!of! the!company.!!! ! The!sample!will!consist!of!two!specific!time!periods.!The!period!before!the!crisis! will!be!from!2004!until!2006!and!the!period!after!the!crisis!will!be!from!2010!until!2012.! These! periods! are! chosen! because! this! research! wants! to! investigate! the! effect! of! the! crisis!itself!and!the!different!legislations!on!the!compensation!structure!and!riskStaking.!! So!the!period!between!2007!and!2009!is!ignored!whereas!this!time!period!represents! the!crisis!itself.!Also,!the!U.S.!started!to!develop!and!implement!new!laws!after!2009!as!a! reaction!to!the!crisis!(e.g.!the!DoddSFrank!act).!! !! ! ! !
B.$Variables*
B.1.$Dependent$variables$
!
Stock!return!volatility!
The! volatility! on! the! stock! returns! is! chosen! as! a! marketSbased! proxy! for! riskStaking.! This!variable!is!an!appropriate!proxy!for!riskStaking!because!stock!return!will!be!more! volatile!when!the!CEO!decides!to!invest!in!a!risky!project!since!he!is!not!sure!whether! the! project! will! increase! or! decrease! firm! value.! So! it! is! uncertain! what! the! return! on! equity!will!be.!Overall,!a!higher!stock!return!volatility!results!in!higher!risk.!
! Daily!stock!prices!are!collected!for!all!firms!for!the!years!2004!to!2006!and!2010! to!2012!and!for!each!day!the!stock!return!is!calculated.!These!daily!returns!are!used!to! calculate! the! stock! return! volatility! for! each! year.! We! did! not! take! into! account! any! dividends! and! calculated! the! equalSweighted! return! (i.e.! the! calculation! does! not! consider!the!market!capitalization!of!the!company).!!
! !!
The!zSscore!
For!this!research!we!also!use!a!nonSmarketSbased!proxy!for!riskStaking,!which!is!the!zS score! credit! risk! model.! This! is! a! commonly!used! model! for! assessing! the! distress! of!
companies!and!it!measures!the!distance!to!default,!i.e.!the!probability!that!the!value!of! debt!will!exceed!the!value!of!its!assets!(Laeven!and!Levine,!2009;!Houston,!et!al.,!2010).! The!higher!the!score,!the!lower!the!probability!of!default!and!the!more!stable!is!the!firm.! In!other!words,!the!higher!the!zSscore!the!lower!the!risk.!This!model!is!chosen!because!it! provides!an!objective!measure!of!soundness!of!all!different!financial!institutions!(Čihák! and!Hesse,!2010).!The!model!is!defined!as! ! ! ! ! ! ! ! ! ! ! ! (1)! ! ! where!ROA!is!the!return!on!assets,!CAR!is!the!capital!asset!ratio,!which!is!total!equity! divided! by! total! assets! (i.e.! average! return! as! a! percent! of! asset),! and!!(ROA)! is! the! standard!deviation!of!return!on!asset,!which!is!a!proxy!for!return!volatility.!The!average! ROA!and!CAR!are!taken!for!the!years!2004!to!2006!and!2010!to!2012!for!each!company.! The!ROA!data!of!the!years!2004!to!2006!and!2010!to!2012!for!each!company!are!used!to! calculate!the!standard!deviation.!!So!overall,!the!zSscore!is!the!score!for!each!company!in! the!period!before!and!after!the!crisis.!! ! Z!score =!"# + !"# !(!"#)
!
B.2.$Independent$variables$
!
The! independent! variables! represent! the! different! components! of! executive! compensation! and! total! executive! pay.! This! research! will! focus! on! base! salary,! annual! bonus,!optionSbased!compensation!and!common!stock!as!the!components!of!pay.!Base! salary! is! the! yearly! fixed! salary! of! the! CEO,! the! annual! bonus! is! the! yearly! shortSterm! cash!incentive!payment,!and!optionSbased!compensation!and!common!stock!is!the!longS term! incentive! payment.! Both,! the! base! salary! and! annual! bonus! are! standardized! by! total! assets! and! a! dummy! variable! is! used! for! the! optionSbased! compensation! and! common!stock!which!is!equal!to!one!if!it!is!granted.!Also,!we!look!at!the!proportion!of! cashSbased! compensation! and! marketSbased! compensation.! The! cashSbased! compensation! consists! of! the! base! salary! and! annual! bonus,! while! the! marketSbased! compensation!consists!of!the!optionSbased!compensation!and!common!stock.!!
!
B.3.$Governance$score$(B<Index)$
!
The!BSIndex!of!Baber,!Liang!and!Zhu!(2012)!is!used!to!measure!the!quality!of!corporate! governance.! It! is! an! internal! governance! measure! and! focuses! on! the! role! of! director,! CEO!independence,!and!the!size!of!the!board.!A!higher!score!means!that!the!corporate! governance!system!is!stronger!and!that!it!is!more!able!to!monitor!and!prevent!the!CEO! from!enriching!himself.!!!
! The!BSIndex!is!composed!of!the!following!six!board!elements!and!will!increase! by! one! if:! (1)! more! than! 75%! of! the! board! members! are! independent,! (2)! all! the! members! of! the! audit! committee! are! independent,! (3)! all! the! members! of! the! compensation! committee! are! independent,! (4)! there! is! an! independent! and! individual! nominating!committee,!!(5)!the!CEO!is!not!the!chairman!of!the!board,!(6)!the!board!size! is!less!than!the!median!of!the!firms!within!the!specific!financial!institution!group.!! ! A!dummy!variable!is!used!for!each!of!the!six!elements!and!is!equal!to!one!if!the! firm!complies!with!the!condition.!Then!the!sum!is!taken!of!all!the!elements!to!get!the!BS index.! ! B.4.$Control$variables$
!
To! mitigate! the! endogeneity! problem! of! omitted! variables,! other! control! variables! are! included! which! will! enhance! the! power! of! the! independent! variable.! First! of! all,! CEO!
characteristics! are! included! to! control! for! executive! compensation.! These! include! the! age!of!the!CEO!and!the!years!of!being!the!CEO!of!the!company!(i.e.!the!older!the!person! and!the!longer!it!works!as!a!CEO,!the!more!compensation!he!receives!due!to!experience).! Another!control!variable!for!executive!compensation!is!board!composition.!Core,!et!al.! (1999)! state! that! firms! with! weaker! governance! structures! have! greater! agency! problems,!which!again!has!a!positive!effect!on!executive!compensation.!This!paper!show! that! the! number! of! outside! directors! has! a! negative! effect! on! executive! compensation! and!that!board!size!has!a!positive!effect!on!executive!compensation.!Therefore!are!the! number! of! outside! directors! and! board! size! used! as! control! variables! for! executive! compensation.! As! a! control! variable! for! profitability,! the! return! on! assets! will! be! included!in!the!regression.!Also,!the!firm!size!is!included!as!a!control!variable!for!riskS taking,!which!is!the!natural!logarithm!of!employees.!The!rationale!behind!this!is!that!the! bigger!the!firm,!the!more!stable!the!firm!is!and!the!more!risk!it!can!take!whereas!it!can! recover! more! easily! from! mistakes.! Another! control! variable! for! riskStaking! is! the! amount!of!debt!within!the!company!over!total!assets.!Debt!could!have!an!influence!on! the! riskStaking! behavior! of! the! CEO,! based! on! the! theory! of! the! agency! cost! of! debt.! Lastly,!the!yearly!average!deviation!of!the!index!return!of!the!S&P!1500!financial!sector! is! used! to! control! for! systematic! risk.! This! is! calculated! by! using! the! monthly! index! prices.! Moreover,! company! fixed! effects! and! year! dummies! are! included,! due! to! unobservable!variables!which!have!an!effect!on!riskStaking.!However,!it!should!be!noted! that! there! is! also! a! probability! of! reverse! causality.! This! means! that! riskStaking! could! also!influence!the!executive!compensation!package.!Therefore!an!IV!method!should!be! used,! however! there! is! not! an! appropriate! exogenous! instrument! for! riskStaking.! Therefore,!we!should!take!into!account!that!the!results!can!be!biased.!!
! !!
C.$Descriptive$statistics*
!
Table! 2! shows! the! descriptive! statistics! of! the! total! sample! for! the! period! before! and! after!the!crisis.!The!total!sample!consists!of!1037!observations,!of!which!there!are!443! observations!for!the!period!2004!to!2006!and!594!observations!for!the!period!2010!to! 2012.! So! overall! the! sample! is! bigger! for! the! period! after! the! crisis.! The! table! reports! that!the!stock!return!volatility!is!lower!and!the!zSscore!is!higher!in!the!period!before!the! crisis!than!in!the!period!after!the!crisis,!which!indicates!that!firms!are!less!stable!in!the! aftermath! of! the! crisis.! The! high! standard! deviations! of! the! zSscore! also! indicates! that! there! is! a! considerable! crossSsectional! variation! in! the! level! of! firm! risk.! In! terms! of!
compensation,!the!amount!of!annual!bonus!and!option!grants!declined!significantly!after! the! financial! crisis.! In! contrast,! firms! raised! the! base! salary! and! common! stock! grants! during! the! period! 2010! to! 2012.! We! can! also! see! that! cashSbased! compensation! component! became! more! important,! in! that! it! grew! from! 71%! to! 82%! of! total! compensation,!while!the!marketSbased!compensation!component!declined!from!29%!to! 18%.!Moreover,!the!value!of!total!compensation!declined!considerable!from!$4,519,200! to! $1,786,300! after! the! financial! crisis.! However,! the! high! standard! deviation! again! indicates!a!significant!variation!among!firms.!When!looking!at!the!control!variables,!we! only!see!that!the!ROA!and!index!return!volatility!has!changed!notable!after!the!financial! crisis.!The!ROA!declined!from!3.1%!to!2.2%!and!the!index!return!volatility!raised!from! 2.4%!to!9.9%.!These!findings!are!supported!by!the!fact!that!financial!institutions!faced! financial! difficulties! after! the! crisis.! The! average! firm! size! is! approximately! between! 12,000! and! 12,900! employees,! which! is! reasonable! because! this! research! focuses! on! listed! companies.! Also,! a! high! debt! ratio! is! normal! for! a! financial! institution,! which! is! here! about! 80%.! When! looking! specifically! at! the! board! in! financial! institutions,! it! consists! approximately! of! 70%! to! 80%! independent! members! with! an! average! board! size!of!11!members.!Furthermore,!the!average!CEO!is!57!years!old!and!is!CEO!for!about!8! years.! The! range! of! the! age! and! years! of! experience! in! financial! institutions! is! broad,! which!is!36!to!81!years!and!0!to!45!years,!respectively.!!
! Table! 3! makes! a! distinction! between! the! three! groups! of! financial! institutions! (i.e.$ Panel! A,! B! and! C)! and! presents! the! differences! between! the! dependent! and! independent! variables.! Overall,! the! table! supports! the! previous! findings! regarding! the! dependent!and!independent!variables.!Nevertheless,!it!is!noticeable!that!there!are!some! main!differences!among!the!three!groups.!First!of!all,!insurance!companies!have!overall! the! lowest! average! zSscore,! followed! by! investment! institutions! and! depository! institutions! have! the! highest! average! zSscore.! This! suggests! that! insurance! companies! are!the!least!stable!and!riskier!compared!to!the!other!two!groups.!When!looking!at!the! stock! return! volatility,! depository! institutions! have! the! highest! rate! after! the! crisis,! followed!by!investment!institutions!and!insurance!companies!have!the!lowest!rate.!!This! means!that!depository!institutions!are!riskier!than!its!peers!after!the!crisis.!In!contrary,! investment!institutions!face!the!most!risk!in!the!period!before!the!crisis!than!its!peers.! Moreover,! investment! institutions! pay! their! CEOs! the! most,! with! a! total! compensation! value! of! $6,607,000! before! the! crisis! and! $2,254,000! after! the! crisis.! This! value! also! declined!the!most!compared!to!the!other!two!groups,!with!$4,353,000.!When!looking!at! the!individual!pay!components,!investment!institutions!paid!a!higher!annual!bonus!and! granted!more!common!stock.!Insurance!companies!paid!a!higher!base!salary.!The!total!
amount!of!option!grants!is!the!highest!in!depository!institutions!in!the!period!before!the! crisis!and!is!162,!while!the!highest!amount!option!grants!is!66!in!insurance!companies! in!the!period!after!the!crisis.!!Again,!we!see!that!cashSbased!compensation!became!more! important! after! the! crisis,! but! it! is! noticeable! that! this! change! is! more! significant! for! depository!institutions!which!went!from!a!cashSbased!percentage!of!71!to!88.!!
! Table!4!displays!the!average!BSindex!for!all!financial!institutions!and!for!each!of! the! three! groups! for! the! period! before! and! after! the! crisis.! The! BSindex! could! not! be! calculated! for! the! total! sample,! and! only! consists! of! 866! observations.! The! findings! suggest! that! most! of! the! firms! have! an! average! BSindex! of! 4! in! the! period! before! the! crisis,!which!means!that!the!corporate!governance!is!of!relatively!high!quality.!However,! it! can! be! seen! that! there! is! a! trend! to! increase! the! strength! of! the! governance! system! after!the!crisis,!which!could!be!as!a!consequence!of!new!and!stricter!regulations.!So!do! most!of!the!depository!institutions!and!investment!institutions!have!a!BSindex!of!5.!Also,! we!can!notice!that!more!insurance!companies!have!an!index!of!5,!whereas!it!increased! considerable!from!16.9%!to!21%!!!
! Lastly,! we! also! look! at! the! correlation! among! all! the! variables.! First! of! all,! the! findings!of!table!5!show!that!the!two!riskStaking!measures,!the!zSscore!and!stock!return! volatility,! are! highly! negative! correlated! at! a! 1%! significance! level.! This! is! valid! since! both! variables! measure! the! same! concept.! A! higher! zSscore! means! lower! risk! while! a! higher!stock!return!volatility!means!higher!risk.!!So!the!zSscore!will!go!down!when!the! stock!return!volatility!goes!up.!The!index!return!volatility!will!also!negatively!influence! the!stability!of!the!firm,!where!it!will!decrease!the!zSscore!and!increase!the!stock!return! volatility.! Leverage! also! influence! the! zSscore! negatively.! This! table! also! shows! the! relationship!between!the!individual!compensation!components!itself!and!other!factors.! We! can! conclude! from! the! correlation! matrix! that! marketSbased! compensation! has! a! negative! effect! on! riskStaking! while! cashSbased! compensation! has! a! positive! effect! on! riskStaking.!This!is!also!supported!by!the!individual!compensation!components,!where! common! stock! has! a! positive! effect! on! riskStaking! and! stock! options! a! negative! effect.! This!finding!is!interesting!since!we!expect!that!marketSbased!compensation!incentivize! the! CEO! to! take! on! more! risk.! On! the! other! hand,! the! correlation! between! the! annual! bonus! and! stock! return! volatility! does! support! our! theory,! where! it! is! highly! negative! correlated!at!a!1%!significance!level.!Which!means!that!the!higher!the!bonus,!the!more! likely!it!is!that!the!CEO!will!take!excessive!risk!to!reach!the!target.!Moreover,!the!base! salary!and!annual!bonus!increases!when!the!firm!will!grant!more!longSterm!incentives! (i.e.$common!stock!and!stock!options),!as!a!compensation!for!the!risk!they!will!face!and! to!incentivize!the!CEO!to!also!focus!on!the!shortSterm.!The!table!also!concludes!that!a!
firm!with!a!bigger!board,!more!outside!directors,!more!debt,!and!an!older!CEO!will!pay!a! higher!base!salary!to!its!CEO.!Also,!a!large!firm!will!pay!a!higher!base!salary!and!annual! bonus,!and!grant!more!stock!options!and!common!stock!compared!to!small!firms.!Lastly,! a!firm!with!a!stronger!corporate!governance!system!will!pay!a!lower!annual!bonus!and! grant!less!stock!options.!This!finding!supports!the!theory!that!higher!quality!boards!will! limit!the!riskStaking!behavior!of!the!CEO.!!
III.!Research!methodology!
!
This!research!will!examine!the!relationship!between!executive!compensation!and!riskS taking! by! financial! institutions! before! and! after! the! recent! financial! crisis.! In! order! to! examine! this! relation,! the! program! STATA! will! be! used! and! an! appropriate! regression! model! will! be! defined.! This! regression! model! consists! of! the! different! components! of! executive! pay! as! dependent! variables,! and! a! suitable! marketSbased! and! nonSmarketS based! proxy! for! riskStaking! as! independent! variables.! Moreover,! control! variables! and! fixed! effects! are! included! to! control! for! specification! bias! and! to! mitigate! the! endogeneity!problem.!!! ! !! First,! a! tStest! will! be! used! in! order! to! examine! whether! the! value! of! total! compensation!and!the!values!of!the!different!components!of!the!compensation!package! is! significant! different! after! the! financial! crisis.! This! means! that! we! will! test! the! H0! hypothesis!(i.e.$there!is!no!difference!in!value!between!the!period!before!and!after!the! crisis)!against!the!H1!and!H2!hypotheses!(i.e.$the!value!is!greater!in!the!period!before! the!crisis!and!the!value!is!greater!in!the!period!after!the!crisis,!respectively).!This!will! give!us!a!better!understanding!of!the!effect!of!the!crisis!on!the!compensation!structure.! ! Secondly,! a! regression! will! be! performed! in! order! to! examine! the! effect! of! the! different!compensation!components!on!riskStaking.!The!following!formula!will!be!used!
! !
! ! ! ! ! ! ! ! ! ! (2)!
!
where!Yi,t!are!the!riskStaking!measures!zSscore!and!stock!return!volatility.!Xi,t!represent! the! different! independent! variables! which! are! base! salary! over! total! assets,! annual! bonus!over!total!assets,!a!dummy!variable!that!is!equal!to!1!if!the!CEO!received!options! and! a! dummy! variable! that! is! equal! to! 1! if! the! CEO! received! common! stock.! Also,! the! cashSbased! and! marketSbased! compensation! proportions! will! be! used.! The! cashSbased! compensation! consists! of! the! base! salary! and! annual! bonus,! while! the! marketSbased!
compensation!consists!of!the!optionSbased!compensation!and!common!stock.!These!are! divided! by! total! compensation! in! order! to! get! the! proportions.! Moreover,! the! control! variables!and!company!and!year!fixed!effects!will!be!included,!which!are!represented!by! Zi,t,!!!!and!!!,!respectively.!Lastly,!the!error!term!is!represented!by!!!,!.!!
! Thereafter,! we! will! focus! particularly! on! the! difference! in! effect! of! executive! compensation!on!riskStaking!before!and!after!the!crisis.!A!tStest!will!be!used!to!examine! whether!the!value!of!the!zSscore!and!stock!return!volatility!significantly!differ!between! 2004! to! 2006! and! 2010! to! 2012.! Then! a! regression! will! be! performed! to! examine! the! difference! in! the! relationship.! The! individual! components! of! executive! compensation! will!be!used!and!also!the!cashSbased!and!marketSbased!compensation!proportions.!This! regression!includes!the!control!variables!as!well!the!company!and!year!fixed!effects.!The! dummy! variable! will! be! equal! to! 0! and! 1! respectively! to! find! the! difference! on! riskS taking!before!and!after!the!crisis.!The!following!model!is!used!
!
! ! ! ! ! ! ! ! ! ! (3)!
!
where! Yi,t!are! the! dependent! variables! which! are! the! standard! deviation! of! the! daily! stock! return! and! zSscore.! Xi,t!represent! the! independent! variables! which! are! the! cashS based! and! marketSbased! compensation! proportions.!!!!is! a! dummy! variable! that! is! equal! to! 1! if! it! is! the! period! after! the! crisis! (i.e.$ 2010! to! 2012).! Zi,t! are! the! control! variables! for! executive! compensation! and! riskStaking.! Company! and! year! fixed! effects! are!!!!and!!!!respectively.!Lastly,!the!error!term!is!represented!by!!!,!.!!!
! Finally,!we!will!also!address!the!indirect!effect!of!the!strength!of!the!governance! structure!on!riskStaking.!The!following!model!is!used!
!
! ! ! ! ! ! ! ! ! ! (4)!
!
where!!!,!!is! the! BSindex! which! is! used! an! interaction! term! with! the! components! of!
executive! compensation! and! the! cashSbased! and! the! marketSbased! compensation! proportion.!!
IV.!Empirical!results!
!
In! this! section! the! results! will! be! discussed.! First! of! all,! the! difference! in! the! overall! compensation! structure! between! the! two! periods! will! be! examined.! Secondly,!
!!,! = !!+ !!!!,!+ !!!!,!!!+ !!!!!!,!+ !!+ !!+ !!,!
!
regressions! will! be! carried! out! to! examine! the! effect! of! the! different! compensation! components! on! the! two! riskStaking! variables! zSscore! and! stock! return! volatility.! Moreover,! we! will! focus! on! the! difference! in! the! relationship! between! executive! compensation! and! riskStaking! in! the! period! before! and! after! the! crisis.! Lastly,! the! corporate! governance! score! will! be! used! as! an! interaction! variable! to! research! the! indirect!effect!of!the!quality!of!corporate!governance!on!the!riskStaking!behavior!of!the! CEO.!
!
A.$The$change$in$executive$compensation$structure$ $
First,! we! examine! whether! financial! institutions! reacted! to! the! crisis,! and! the! new! regulations! and! laws! by! changing! their! executive! compensation! package.! Table! 6! presents!the!results.!First!of!all,!it!can!be!noticed!that!the!mean!values!for!the!variables! annual! bonus,! stock! option! grants! and! total! compensation! differ! significantly! between! the! two! periods,! while! there! is! not! a! big! difference! between! base! salary! and! common! stock!grants.!These!are!the!same!findings!as!in!table!2,!so!we!will!not!go!into!detail.!The! standard! error! measures! the! accuracy! with! which! the! sample! represents! the! total! population.! So! as! we! can! see,! the! number! of! common! stock! grants! is! rather! accurate! with!a!standard!error!of!about!3.!However,!total!compensation!in!the!period!before!the! crisis! has! the! biggest! standard! error! of! 322.8,! which! means! that! mean! value! of! total! compensation! could! be! $322,800! bigger! or! smaller! than! $4,519,200.! Overall,! we! can! conclude! that! after! the! crisis! the! mean! values! are! more! accurate! than! before! the! financial!crisis.!This!could!be!due!to!the!fact!that!the!sample!size!is!bigger!in!the!period! 2010!to!2012!than!in!the!period!2004!to!2006,!whereas!the!standard!error!is!inversely! affected!by!the!sample!size.!!
! When!looking!at!the!pSvalues!under!the!stated!hypotheses,!we!can!conclude!that;! annual! bonus,! stock! option! grants! and! total! compensation! were! higher! in! the! period! before! the! crisis! and! that! base! salary! and! common! stock! grants! were! higher! in! the! period!after!the!crisis.!These!findings!are!highly!significant!at!a!1%!level!and!support!the! stated!hypotheses!1!to!3.!! ! B.$The$effect$of$executive$compensation$on$risk<taking$
!
Tables!7!to!11!present!the!regression!results!for!the!model!in!which!we!study!the!impact! of!the!different!executive!compensation!components!on!the!two!riskStaking!measures!zSscore!and!stock!return!volatility.1!Table!7!include!the!results!for!the!whole!sample!and! show!that!base!salary!has!a!positive!effect!on!the!stock!return!volatility,!which!means! that!CEOs!engage!in!more!riskStaking!activities!if!their!base!salary!increases.!The!stock! return!volatility!will!rise!with!0.441%!due!to!a!higher!base!salary,!and!is!significant!at! the!10%!level.!An!explanation!for!this!could!be,!that!CEOs!will!take!more!risk!when!they! know!they!will!receive!a!high!base!salary!despite!their!decisions.!However,!this!positive! relationship!is!not!supported!when!we!look!at!regression!1,!since!there!is!no!significant! relationship!between!base!salary!and!the!zSscore.!The!results!of!regression!3!and!4!are! not!significant,!so!annual!bonus!does!not!have!an!influence!on!the!riskStaking!behavior! of!the!CEO.!Regression!5!shows!a!more!interesting!result,!it!presents!that!common!stock! has!a!negative!effect!on!the!zSscore!at!a!5%!significance!level.!This!means!that!common! stock!encourages!riskStaking!and!lowers!the!stability!of!the!firm.!When!we!look!at!the! literature,!it!states!that!more!common!stock!will!increase!the!alignment!of!the!interests! of!the!CEO!and!shareholders.!This!means!that!CEOs!will!not!engage!in!activities!that!will! harm!the!firm!and!its!shareholders.!However,!this!thesis!focuses!on!a!financial!insecure! and!unstable!period,!which!could!be!a!reason!for!shareholders!to!favor!more!riskStaking! because!they!had!nothing!to!lose.!Eventually,!CEOs!will!take!more!risk!when!he!receives! more!common!stock!in!order!to!try!to!increase!its!value!again.!Lastly,!stock!options!do! have! a! positive! effect! on! riskStaking.! The! stock! return! volatility! increases! with! 1.19%! when! stock! options! are! granted! to! the! CEO,! which! is! significant! at! a! 10%! level.! This! finding!support!the!literature!that!states!that!stock!options!do!increase!riskStaking.!An! explanation!for!this!is!that!stock!options!only!expose!the!CEO!to!the!upside!potential!and! not!to!the!downside!risk.!This!means!that!CEOs!will!only!benefit!when!the!stock!price!is! above!the!exercise!price!and!will!not!be!punished!if!it!is!below!the!exercise!price.!This! means!that!the!CEO!can!take!on!every!risky!activity!in!order!to!try!to!get!the!stock!price! above!the!exercise!price.!!
! Table! 11! shows! the! regression! of! the! relationship! between! the! cashSbased! compensation! proportion! and! marketSbased! compensation! proportion! on! riskStaking.! The!findings!show!that!cashSbased!compensation!increases!the!stability!of!the!firm!and! lowers! excessive! riskStaking! while! marketSbased! compensation! is! an! incentive! for! the! CEO! to! take! risk.! Both! variables! are! significant! at! a! 10%! level! and! show! that! a! 1%! increase!in!the!cashSbased!proportion!will!increase!the!zSscore!with!40.48!points,!while! a!1%!increase!in!the!marketSbased!proportion!will!lower!the!zSscore!with!40.48!points.! The!CEO!cannot!directly!influence!the!value!of!stock!options!and!common!stock!since!it!
