Risk-taking incentives through excess variable compensation: Evidence from European banks

• Excess variable pay may incentivize managerial risk-taking.
• Granger-causality tests and instrument variable regressions confirm baseline findings.
• Compensation-risk linkage may be stronger in financially distressed banks.
• Pre-crisis compensation may increase bank risk during the financial crisis.
• More generous deposit insurance schemes may spur managerial-risk taking.
• Governmental capital assistance and strong supervisory power may mitigate it.

Employing compensation data provided by 63 banks from 16 European countries for the period from 2000 to 2010 this paper empirically investigates the impact of excess variable compensation on bank risk. As a main finding, we provide evidence for a risk-increasing impact of excess variable pay for both executive variable cash-based and variable equity-based compensation. This baseline finding holds under various robustness checks, in particular when controlling for likely reverse causality between bank risk and variable compensation by employing Granger-causality tests and instrumental variable regressions. In addition, results from a large number of sensitivity analyses including board and banking characteristics as well as the financial crisis period and the quality of a country's regulatory framework provide further important implications for banking regulators and politicians in Europe.