Edited by James R. Barth, Chen Lin and Clas Wihlborg
Walter Dolde and John D. Knopf 10.1 INTRODUCTION John et al. (2000) suggest that attention to capital ratios alone may not be an efficient way to regulate banks. They demonstrate theoretically that the structure of manager compensation plays an important role in bank risk-taking. These authors propose, therefore, that US Federal Deposit Insurance Corporation (FDIC) insurance premiums reflect each bank’s compensation structure and the associated incentives to take risks which may result in failure. In this chapter we examine the relationship between chief executive officer (CEO) compensation and the likelihood of failure for a large sample of publicly traded banks and thrifts in the USA. After controlling for capital ratios, we find that the structure of CEO compensation has a significant impact upon the probability of failure, consistent with John et al. (2000). Specifically, we split CEO compensation into salary, bonus and equity (stock awards and option awards). We find that salary and equity compensation are inversely related to failure, while bonus compensation is positively associated with the probability of failure. We attribute these findings to the incentive effects of different forms of compensation. If the firm fails, the manager may well be terminated, in which case the present value of future salary collapses. Similarly stock and option compensation may be indicative of the manager’s equity in the firm, which also disintegrates in a failure. Bonuses are less likely to be serially correlated and are also more reflective of short-term performance, providing greater incentive for exposure to risk and insolvency....
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