As financial historians, researchers, and analysts attempt to explain and identify the causes of the financial crisis, excessive risk-taking emerges as an important explanation.  According to evidence from new research by Finance Professors Swaminathan Kalpathy and Amar Gande, U.S. Federal Reserve emergency financial assistance ("bailouts") is higher among firms whose CEOs have stronger risk-taking incentives.  In “CEO Compensation at Financial Firms,” the authors disentangle whether the incentives inherent in CEO compensation contributed to the financial crisis.  This is the first paper to use the recently available data from the bailouts to assess some of the damage.

The study presents evidence that CEO compensation contracts may have embedded incentives for CEOs to take on excessive risks.  This paper adds to the literature by explaining whether or not executive compensation incentives had a role to play in incentivizing financial firms CEOs to undertake excessive risks prior to the financial crisis.  The authors use a novel dataset of emergency capital provided by the U.S. Federal Reserve to eighty-three large financial firms (for which executive compensation data exists) through five government programs during the crisis period of 2007-2010.  The typical financial firm that receives financial assistance has an average market capitalization of $21 billion and average book value of assets of nearly $80 billion.

Bailouts are considered to be an ex-post (or after the fact) measure of the excessive risk-taking before the crisis.  “Our underlying assumption is that if an executive is involved in certain types of risk-taking, the crisis exposed and measured the outcome of those risk-taking activities,” says Kalpathy.  “The bailout is an outcome [in this case].”  Further, the authors questioned whether the incentives set prior to the crisis had any ability in explaining the variation in how much assistance a financial institution received during the crisis.  Findings suggest that equity incentives embedded in CEO compensation contracts are positively associated with risk-taking in financial firms.

Federal emergency capital as proxy

The authors suggest that Federal emergency capital assistance serves as an empirical proxy for the true financial health of these financial firms.  The amount of assistance received by financial firms is likely a better signal of financial health than accounting- or stock price-based measures of firm performance derived from financial statements.  Earlier research finds that banks used the discretion provided in mark-to-market accounting rules by recording the value of distressed assets at their historical costs, thus overstating their value in financial statements.  Moreover, capital assistance received reflects private information of a firm’s financial health, which is observed by regulators and corporate managers.  Given that stock market participants may not have access to such private information, a bailout received by a financial firm is likely to be a better signal of financial health than stock performance measures. The study also parsed the meaning of receiving assistance early in the crisis (2007-08) compared to assistance later in the crisis (2009-10).  Firms that receive federal financial assistance during the earlier part of the crisis are presumably more likely to face “liquidity” problems.  “In the early part of crisis, in late 2007 and 2008, banks were accessing funds because of liquidity freezing up, which was Fed’s motivation for the facilities,” says Kalpathy.  “As events first unraveled, and then subsequently became more stable, firms that requested funds for liquidity had stopped accessing bailout money.”

However, the same bank would sometimes come back again later for funding, according to the authors.  Thus, some banks were still in distress. This is why these programs still continued even into early 2010.  "In the early days, liquidity was the primary motive," Kalpathy reiterates.  "If it was beyond liquidity (which was hard to disentangle), then it is more of a solvency effect, as our study revealed.  Later receivers of funds tended to have stronger CEO incentive effects and the need for solvency,” Kalpathy notes.  “Some of the troubled firms continued to remain troubled and needed funds during the later period and this seems to have had more to do with risk-taking behavior,” Gande states.  These results also provide some additional evidence that CEO compensation contracts may have embedded in them incentives for their CEOs to take on excessive risks.

Policy implications

“There is a link between excessive risk-taking incentives and bailouts," Gande says.  "We conclude that this issue should be priced in, such as in Federal Deposit Insurance Corporation (FDIC) insurance premiums."  Gande continues, "Moreover, if a firm is receiving bailout money, then the interest rate and amount should be based on incentive features provided by the firm.  Firms, which are cranking up on risk, may see bailouts as less costly money.  If the government wants to address this issue, it should be based on pricing it in, as opposed to direct regulation.  Regulation may not always work since sometimes it has unintended consequences." 

The paper “CEO Compensation at Financial Firms” is authored by SMU Cox Finance Professors Amar Gande and Swaminathan Kalpathy.

Written by Jennifer Warren.