Executive compensation, risk taking and the state of the economy

In this paper we present a model of executive compensation to analyze the link between incentive compensation and risk taking. Our model takes into account the loss in the value of an executive's expected wealth from employment if the firm becomes insolvent during a bad state of the economy. We illustrate that a given compensation package may lead to different levels of asset risk under different economic states. More specifically, we show that the positive relationship between equity-based compensation and risk taking may weaken and possibly disappear during systemic financial crises. An important policy implication from our analysis is that similar regulations may have different effects on risk taking depending on the state of the economy.

► A model in which executives’ risk taking in financial institutions depends on the state of the economy is presented.
► Risk taking incentive of an executive is affected by her loss due to systemic crisis – her wealth loss in firm's insolvency during a systemic crisis.
► We show that a manager's optimal choice during bad states of the economy (i.e. systemic crisis) is to target a lower level of asset risk.
► The model shows that similar pay packages may motivate the executive to take different risk under different states of the economy and leverage.