“CEO Incentives and Bank Risk over the Business Cycle”
by Tanseli Savaşer
Assistant Professor of Finance – Faculty of Business Administration
Due to government guarantees provided to financial firms, bank shareholders have a natural preference for risky lending, taking excessive risks at the expense of debt holders and taxpayers (risk shifting). We propose and test a joint hypothesis that these risk-shifting incentives become more prominent as economic conditions deteriorate and that shareholder’s increased risk appetite leads to a stronger relationship between managerial risk-taking incentives and bank risk in a contracting economy. Consistent with this hypothesis, we find that the same level of pay-for-risk incentives given to a CEO leads to higher bank risk during economic downturns. This is because shareholders’ increased risk preference is passed on to the manager (through stock-based compensation) increasing the sensitivity of bank risk to CEO pay-for-risk incentives. Our results suggest that holding sufficiently high amount of bank capital limits this effect, making the CEO compensation-bank risk relationship less sensitive to the underlying macroeconomic environment.