Reexamination of risk-taking incentives in banking: Realign incentives and curtail future episodes of mismanagement

CEO incentive compensation, in particular the equity-based compensation, has been blamed for excessive risk-taking by bank CEOs in the recent financial crisis. This study reassesses the impacts of deregulation on the incentives provided to CEOs and examines how bank boards redesigned CEO compensation contracts during and after the crisis to assess if the government interventions are necessary to realign incentives between CEO and shareholders. Employing a multiple-equation model that allows for simultaneity among vega, delta, and bank investment, I found that banks provided high-vega contracts as incentives for bank CEOs to exploit post-deregulation growth opportunities and to shift from traditional on-balance sheet portfolio lending to nontraditional fee-generating activities. No evidence shows the relation between incentive compensation and risk-taking activities before deregulation. In the crisis and post-crisis period, compensation committees attempted to manage excessive risk-taking incentives at these banks by reducing vega and establishing complementarily high values of delta to align incentives between CEOs and shareholders. Especially in the post-crisis period, the value of vega has been decreased significantly, suggesting government intervention of bank's CEO compensation works effectively to reduce bank risk.