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Journal of Management and Governance

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01-03-2018

Executive compensation in banks: insights from CEO equity incentives and securitization transactions

Author: Michele Fabrizi

Published in: Journal of Management and Governance | Issue 4/2018

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Abstract

This paper investigates whether CEO equity incentives promote risk-taking activities in the financial industry. Prior research shows that, during the recent credit crisis, banks whose CEOs had high equity incentives performed significantly worse than banks whose CEOs had low equity incentives. A possible explanation for this result is that the incentive to boost stock price induced CEOs to take risks that turned out to be extremely costly. Focusing on securitization transactions that were among the fundamental causes of the financial crisis and using a sample of US financial institutions, the paper provides evidence that banks whose CEOs had high equity incentives engaged in securitization transactions to a greater extent than did financial institutions guided by CEOs with low equity incentives. Moreover, the paper shows that CEOs with high equity incentives securitized riskier loans than did CEOs with low incentives. This study helps to clarify the role of equity-based compensation in promoting risk-taking behaviors in banks.

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I limited the analysis to the period 2003–2009 to ensure that data were comparable over time and were not affected by changes in accounting standards and regulations.

In order to avoid a mechanic relation between the variables Securitization and Subprime, I do not define this variable for all observations. I investigate this point further in Sect. 4.2.

If the financial institution was not subject to regulatory capital requirements, the variable was set at 0.

Since the average value of the variable Securitization in the sample is 0.0537316, the economic significance of the estimates is computed as (0.016/100)/0.0537316 = 0.298%.

Since the average value of the variable Losses in the sample is 0.0181335, the economic significance of the estimates is computed as (0.006/100)/0.0181335 = 0.331%.

Because of data limitations, the compensation data considered date back to 1992.

Even if the data corroborate the assumption that the securitization business model that generated the financial crisis came into existence only after the introduction of SFAS 140, we cannot ignore the fact that securitization transactions were also present before 2000. I acknowledge that the instrument is likely to be semi-endogenous and not perfectly exogenous (Larcker and Rusticus 2010). If the previous CEO’s compensation was missing, the sample’s median was used. A Hausman test verifies that the specified endogenous regressor cannot be treated as exogenous, as the test strongly rejects the null hypothesis that CEO equity incentives are exogenous (p value = 0.000). Moreover, the Stock-Yogo test produces an F-statistic of 23.86, so the null hypothesis of a weak instrument is rejected.

The analysis is not limited to a 3SLS approach because—even if this estimation method is more efficient - it relies on a number of exclusion restrictions that bear some subjectivity. Indeed, in a 3SLS approach some variables are only included in stage 1 while other variables are only included in stage 2. In contrast, in the 2SLS approach, all control variables from the second stage are also included in first stage, as shown in Table 7. Thus, using both a 3SLS and a 2SLS approach allows me to provide efficient estimates but at the same time to assure that exclusion restrictions are not driving the results.

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Title: Executive compensation in banks: insights from CEO equity incentives and securitization transactions
Author: Michele Fabrizi
Publication date: 01-03-2018
Publisher: Springer US
Published in: Journal of Management and Governance / Issue 4/2018
Print ISSN: 1385-3457
Electronic ISSN: 1572-963X
DOI: https://doi.org/10.1007/s10997-018-9407-y

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