Non-Executive Incentives & Bank Risk-Taking Viral Acharya (NYU Stern, NBER & CEPR) Lubomir P. Litov (Univ. of Arizona & WFC, Univ. of Pennsylvania) Simone M. Sepe (Toulouse School of Economics & Univ. of Arizona) May 18 th 2013 American Law & Economics Association Meeting, Vanderbilt University

2 Research Questions What is the effect – if any – of non-executive compensation policies on bank risk-taking? Determinants of such policies? Normative implications?

3 Motivation High-powered performance incentives to non-executives implied losing them to competitors that were unwilling to “stop dancing” (Rajan, 2010). Role for competition in determining non-executives’ incentives. Clear contrast with dominant view in law and finance literature: Executive incentives determine non-executive incentives (e.g., Bebchuk & Fried, 2010). Hence bank risk-taking is seen as an executive incentive alignment problem.

4 Motivation “As long as the music is playing, you’ve got to get up and dance.” “We’re still dancing.” (Charles Prince)

5 Two Empirical Hypotheses Non-executive compensation before the crisis only rewarded short-term performance but was insensitive to long-term performance (i.e., risk), which led to excessive bank risk-taking and lower bank values. Bank competition for non-executives was largely responsible for the distortions in non-executive compensation.

6 Executive Compensation Fahlenbrach & Stulz (2011). Bebchuk & Spamann (2010). Non-Executive Compensation Overall literature on non-executive compensation incentives is limited in scope of investigation due to limited cross- sectional data availability. Experimental Data Cole,Kanz & Klapper (2012) and Agarwal & Ben-David (2012). Single Lender Data Berg, Puri, & Rocholl (2012); Hertzberg, Liberty, & Paravisini (2011); and Gee & Tzioumis (2012). Bank Risk Taking: Deposition Insurance & Competition → Keeley (1990). Ownership & Banking Regulation → Laeven and Levine (2009). Bank Size → Demsetz and Strahan (1997). Bank Franchise Value → Demsetz, Saidenberg, & Strahan (1997). Monetary Policy → Landier, Sraer and Thesmar (2011). Creditor Rights → Houston et al. (2010). Risk Management → Ellul and Yerramilli (2012).. Prior Literature

7 -Cash compensation elasticity has a positive and significant effect on bank risk taking. -Equity compensation elasticity has a negative and mostly significant effect on bank risk taking. -Effect of non-executive incentives on risk-taking is primarily through incentives specific to peer-group performance. -Cash incentives to above-peer group performance is more important in determining risk taking. -Non-executive cash compensation incentives lowered bank value, while non- executive stock compensation incentives increased bank value. Main Findings & Contributions

8 -We contribute to the literature on bank risk taking by outlining an important factor to influence bank risk taking. -Document an inefficiency in the compensation structure of bank non- executives. -We also contribute to the literature on employee stock-ownership, by showing that such plans add value through curbing bank risk taking incentives. -Methodologically, outline a novel cross-sectional proxy for non-executive incentives. Main Findings & Contributions

9 Data Collect Data from a Bank Regulatory Database. Contains information on quarterly bank holding company disclosure collected by the Federal Reserve Bank of Chicago. Collect data on 77 Bank Holding Companies (BHC): Involve only banks with available data. Other data: ExecuComp (for CEO incentives), Option Metrics, CRSP, Compustat.

10 The Empirical Problem of Incentives

11 The Empirical Problem of Incentives

12 Non-Executive Compensation Elasticity Measures of Incentives ( ): Elasticity of MM compensation: quarterly variation of total compensation over quarterly variation of Total Interest Income (TII), Net Interest Income (also Loan and Losses Provisions), EBITDA (Free Cash Flows) Maximal elasticity with respect to Total Interest Income Banks reward volume rather than quality!

13 Key Independent Variables

14 Non-Executive Elasticity & Bank Risk-Taking Measures of Risk ( ): (1) Aggregate Risk; (2) Tail Risk; (3) Implied Volatility; (4) Z-Score. Non-executive cash compensation incentives positively impact bank risk-taking. In , the effect of MM cash compensation on risk is between 29.5% and 35.9%, instead effect of CEO compensation is 5.7%! Non-executive stock compensation incentives negatively impact bank risk-taking, but stock incentives are only 2%!

15 Cash & Stock Compensation Effects (Table 7) Dep. Variable:Tail Risk Independent Variables:(1)(2)(3)(4) *** *** t-stat (2.83)(3.71) ** *** t-stat (2.0)(3.80) ** t-stat (2.16) CEO Delta (mean ) * ** * t-stat (1.92)(1.64)(2.03)(1.75) CEO Vega (mean ) t-stat (1.13)(1.17)(1.05)(1.10) (control variables not shown for brevity)

16 Cash & Stock Compensation Effects (Table 7) – Alternative Risk Measures Dep. Variables:Aggregate Risk Implied Volatility Z-Score Independent Variables:(1)(2)(3)(4) (5)(6)(7)(8) (9)(10)(11)(12) *** *** ** ** *** *** t-stat (4.91) (5.62) (2.49) (2.36) (3.44) (3.68) * ** t-stat (1.57) (1.95) (1.01) (0.71) (2.28) (0.86) *** 0.72 *** *** t-stat (3.75) (2.81) (3.57) CEO Delta (mean ) *** ** *** t-stat (0.73)(1.20)(0.49)(0.89) (0.82)(1.21)(0.81)(0.80) (2.72)(2.05)(0.20)(3.75) CEO Vega (mean ) ** * * ** *** *** *** *** t-stat (1.2)(1.22)(1.12)(1.15) (1.99)(1.79)(1.91)(2.01) (4.76)(3.67)(4.39)(4.82) (control variables not shown for brevity)

17 Employee Turnover (Table 10A) Panel A. Tail Risk Control Variables(1)(2)(3)(4) 0.06 ** 0.07 *** t-stat (2.23) (3.03) t-stat (0.79) (1.51) 0.06 ** t-stat (2.29) *** 0.18 *** t-stat (2.73) (3.36) *** ** t-stat (2.62) (2.25).039 *** t-stat (2.79) Employee Turnover ( ) * t-stat (0.68)(1.72)(0.54)(1.15) (control variables not shown for brevity)

18 Excess Cash Compensation (Table 10B) Panel B. Tail Risk Control Variables(1)(2)(3)(4).053 **.063 *** t-stat (2.18) (2.55) ** *** t-stat (2.26) (4.1).051 ** t-stat (2.21) * * t-stat (1.93) (1.67) t-stat (1.02) (0.62) * t-stat (1.74) Excess Cash Compensation (estimated ) *** t-stat (0.11)(3.91)(0.42)(0.55) (control variables not shown for brevity)

19 Competition Effect To verify the relationship btw competition for non-executives & their incentives, we consider: - Sensitivity of non-executive compensation to bank-specific performance & market performance. - Impact of turnover (as proxy for competition). Non-executive compensation more sensitive to market performance Turnover positively impacts bank risk-taking. Above-the-market compensation (excess wage) negatively impacts bank risk- taking.

20 Peer Effects Estimation where Peer-Specific Performance is defined as:

21 Peer Group Choice Empirical challenge is to identify the peer group as it is possible that peer group performance is driven by a common latent factor. Potential solution: choose a different reference group for different banks. Heterogeneity in peer group choice allow use performance of the “peer’s peer” as a relevant instrument to capture the peer group’s performance. Example. Bank A 1 has peer group of banks (A 2, B 1 ). Bank B 1 has a peer group of banks (B 2, A 1 ). B 2 performance relevant instrument for A 1 performance because: 1.Relevant to A 1 performance (influences performance of its direct peer B 1 ) & 2.Exclusive to A 1 performance (achieves effect on A 1 ’s performance only through peer group.)

22 Market Short-Term Performance Effect (Table 8) Dep. Variables: Tail Risk Aggregate Risk Implied Volatility Z- Score Independent Variables:(1)(2)(3)(4)(5)(6)(7)(8) ** ** *** *** *** ** *** *** t-stat (2.58)(2.5)(6.31)(5.2)(2.68)(2.25)(8.45)(7.91) *** *** t-stat (0.27) (3.19) (5.32) (1.41) CEO Delta (mean ) *** t-stat (1.31)(1.3)(0.22)(0.32)(1.41)(1.05)(3.1)(3.11) CEO Vega (mean ) *** *** t-stat (0.03)(0.06)(0.59)(0.55)(0.16)(1.03)(2.91)(3.0) (control variables not shown for brevity)

23 Asymmetric Effects Estimation

24 Market Asymmetric Performance Effect (Table 9) Dep. Variables: Tail Risk Aggregate Risk Implied Volatility Z- Score Independent Variables:(1)(2)(3) (4) * * t-stat (0.11)(1.61)(1.42)(1.11) *** *** 0.45 *** *** t-stat (2.75)(2.63)(9.12)(3.19) CEO Delta (mean ) * *** t-stat (1.77)(0.55)(1.05)(4.86) CEO Vega (mean ) ** *** t-stat (0.91)(0.79)(1.98)(4.28) (control variables not shown for brevity)

25 Bank Value (Table 11) Dep. Variable:Tobin’s Q Independent Variables:(1)(2)(3) *** t-stat(3.89) t-stat (0.65) *** t-stat (3.78) t-stat (1.48) CEO Delta (mean ) *** ** *** t-stat(6.64)(2.43)(24.57) CEO Vega (mean ) *** *** ** t-stat(3.27)(3.36)(2.62) (control variables not shown for brevity)

26 Robustness Potential concern with our empirical design is that both pre-crisis incentives and within-crisis risk exposure may reflect the level of BHC specialization in particular product lines (e.g. subprime loans). If such product specialization is not controlled for in our tests, or if it influences dependent and independent variables in these tests in a non-linear way, a correlated-omitted variable bias in our empirical results would arise. To address the endogeneity concern we use a comprehensive sample that extends from 1994 through 2010 and we use an alternative approach based on a system GMM estimation (Arellano and Bond (1991), Arellano and Bover (1995), and Blundell and Bond (1998))

27 GMM Analysis Dep. Variable: Tail Risk Control Variables(1)(2)(3)(4) 0.61 *** 0.68 *** t-stat (6.30)(3.20) *** * t-stat (3.20)(1.80) 0.41 *** t-stat (3.56) CEO Delta (t-1)-.009 *** *** *** *** t-stat(3.10)(2.80)(3.30)(3.0) CEO Vega (t-1).019 ***.015 ***.018 ***.017 *** t-stat(4.20)(3.70)(4.0)(3.90) (control variables not shown for brevity)

28 GMM Analysis Dep. Variable: Aggregate Risk Control Variables(1)(2)(3)(4) 0.47 ** 0.56 ** t-stat (1.98) (2.02) * (1.20) (1.81) t-stat 0.34 * (1.79) t-stat (0.45)(0.61)(0.53)(0.05) CEO Delta (t-1).007 ***.006 *** t-stat(3.80)(4.49)(3.60)(3.55) CEO Vega (t-1)0.47 ** 0.56 ** t-stat(1.98) (2.02) (control variables not shown for brevity)

29 GMM Analysis Dep. Variable: Implied Volatility Control Variables(1)(2)(3)(4) 2.50 *** 2.81 *** t-stat (3.20) (3.90) ** -.02 *** (2.43) (3.12) t-stat 1.18 *** (3.30) * * * t-stat (1.87)(1.65)(1.93)(1.86) CEO Delta (t-1) * t-stat(1.40)(1.89)(1.59)(1.20) CEO Vega (t-1)2.50 *** 2.81 *** t-stat(3.20) (3.90) (control variables not shown for brevity)

30 GMM Analysis Dep. Variable: Z-Score Control Variables(1)(2)(3)(4) *** *** t-stat (4.1) ** * (2.6) (1.8) t-stat *** (4.9) 0.19 ** 0.23 * *** t-stat (2.6)(1.93)(0.3)(3.24) CEO Delta (t-1)-0.3 *** -.18 *** -.28 *** -.29 *** t-stat(4.12)(3.56)(4.12)(4.59) CEO Vega (t-1)-13.2 *** *** t-stat(4.1) (control variables not shown for brevity)

31 Executive Compensation Reform? Improving executive compensation practices not enough to solve the problem of excessive bank risk-taking. Non-executive risk incentives are independent from executive risk incentives. The root of the problem is the negative externality produced by bank competition for non-executives.

32 Limiting Competition for Non-Executives Direct: Making Employment Contracts Relational. No-compete provisions for MM: Property Rule. Pigouvian tax on mobility: Liability Rule. Clawback provisions contingent on mobility. Excess compensation (contracts are less subject to renegotiation). Pigouvian subsidy: Regressive tax (or tax deduction) on compensation based on tenure.

33 Non-Executive Deferred Stock Compensation We find that stock compensation negatively impacts risk-taking, but is only 2% of total compensation. Back-loading stock compensation into future periods increases employer specificity. Rethink ownership between capital and labor providers when moral hazard is severe and cannot be fully controlled by contract. Implementation strategies: - Tough: Mandatory rules - Soft: Tax deduction

34 Thank You.

35 Extra Slide