CEO compensation, regulation, and risk in banks: Theory and evidence from the financial crisis

This paper studies the relation between CEOs' monetary incentives, financial regulation and risk in banks. We develop a model where banks lend to opaque entrepreneurial projects to be monitored by bank managers. Bank managers are remunerated according to a pay-for-performance scheme and their effort is not observable to depositors and bank shareholders. Within a prudential regulatory framework that imposes a minimum capital ratio and a deposit insurance scheme, we study the effect of increasing the variable component of managerial compensation on bank risk in equilibrium. We test the model's predictions on a sample of large banks around the world, gauging how the monetary incentives for CEOs in 2006 affected their banks' stock price and volatility during the 2007-2008 financial crisis. Our international sample allows us to study the interaction between monetary incentives and financial regulation. We find that greater sensitivity of CEOs' equity portfolios to stock prices and volatility is associated with poorer performance and greater risk at the banks where shareholder control is weaker and in countries with explicit deposit insurance.