Inside Debt and Bank Risk

Abstract

Inside debt compensation held by top officers of U.S. banks is negatively related to risk and risk taking. The evidence reveals a robust and strongly negative relation between endof-2006 inside debt and 2007-2009 bank-specific risk exposures in terms of lost stock market value, volatility, tail risk, and the probability of financial distress. Banks with managers having large inside debt holdings are also characterized by better-quality assets, more conservative balance sheet management, and a stronger tendency toward traditional banking activities. The results suggest that debt-based compensation limits bank risk and risk taking by encouraging more conservative decision making.

CEO Inside Debt and Risk Taking: Evidence From Property–Liability Insurance Firms

“…VaR is a statistical measure of downside risk and can be defined as the maximum expected loss that could occur on a portfolio of assets over a given time period at a specified confidence level (Crouhy, Galai, and Mark, ; Jorion, ). Although the number and types of approaches to estimating VaR have been growing exponentially, we follow Van Bekkum () for the purpose of this study.…”

“…Wei and Yermack () show that the average holding of debt‐like compensations for the sample CEOs is $10 million. Van Bekkum () finds that the average value of inside debt for bank CEOs is $4.28 million, and Cassell et al () report that the average value of inside debt for their sample CEOs is $7.05 million. Despite its extensive use as a form of executive compensation, the incentive effects of inside debt have been much less examined compared to those of equity‐based compensation.…”

“…Recent banking studies report that executive debt‐like compensation is an important tool to reduce risk by encouraging more conservative decision making. Van Bekkum () finds that banks with large executive inside debt holdings during prefinancial crisis periods have lower levels of risk exposure in financial crisis periods and large inside debt holdings lead to more conservative investment and financing decisions. Similarly, Bennett, Güntay, and Unal () show that bank holding companies perform better and have a lower default risk during a crisis period when their CEOs hold more inside debt relative to inside equity before the crisis.…”

“…Recent studies show that banks exhibit lower levels of risk‐seeking behavior in a crisis period if their CEOs hold large inside debt during prefinancial crisis periods (Bennett, Güntay, and Unal, ; Van Bekkum, ). These findings somewhat lend support to the regulatory view that the use of compensation arrangements may influence managerial risk‐taking behavior in financial institutions.…”

“…We investigate a market‐based measure of risk to represent managerial risk taking. Consistent with the recent work of Van Bekkum (), we employ value at risk (VaR) and expected shortfall (ES), which capture the downside risk of a firm's stock performance. VaR and ES have been popular measures of risk for the market risk exposure of financial institutions and commonly employed in finance literature to estimate portfolio risk (e.g., Ané and Kharoubi, ; Rosenberg and Schuermann, ; Bali, Demirtas, and Levy, ).…”