Deregulation and the relationship between bank CEO compensation and risk-taking

Deregulation and the relationship between bank CEO compensation and risk-taking The deregulation of the banking industry during the 1990s provides a natural (public policy) experiment for investigating how firms adjust their executive compensation contracts as the environment in which they operate becomes relatively more competitive. Using the Riegle-Neal Act of 1994 as a focal point, we investigate how banks changed the equity-based component of bank CEO compensation contracts. We also examine the relationships between equity-based compensation and risk, capital structure, and investment opportunity set. Consistent with theoretical predictions, we find that after deregulation, the equity-based component of bank CEO compensation increases significantly on average for the industry. Additionally, we find that more risky banks have significantly higher levels of equity-based compensation, as do banks with more investment opportunities. But, more levered banks do not have higher levels of equity-based CEO compensation. Finally, we observe that most of these relationships become more powerful in our post-deregulation period. 3 1. Introduction As Kole and Lehn (1999) point out, our understanding of the dynamics of corporate governance structures is very limited. We do not know very much about how the governance structures of firms change in response to systemic changes in their operating environments. 1 The ability of a firm to adjust to changes in its environment is critical to its survival. However, it is common for researchers to presume that the firms that survive in competitive markets simply possess optimal governance structures and not consider how those structures came into existence (Kole and Lehn, 1999). As a firm's operating environment changes, especially if the new environment is more competitive, the firm either adapts its governance structures accordingly, or the firm exits the market. This is the essence of competition. As firms fight for profits, the competitive paradigm makes some very clear predictions about outcomes. That is, strong performers will pass the market test and therefore survive, while weak performers should shrink, exit, or sell out. This transfer of market share from underperformers to more successful firms is a critical part of the process. However, as Stiroh and Strahan (2003) point out, this stylized picture is not always the reality. Regulations and other barriers to entry can, and often do, protect inefficient firms, limit entry and exit, and overall prevent the natural consequences of the competitive process. 1 Bliss and Rosen (2001) are among the first to examine how changes in firm's operating …