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Working Paper

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Bank executives’ compensation has been widely identified as a culprit in the Global Financial Crisis, and reform of banker pay is high on the public policy agenda. While Congress targeted its reforms primarily at bankers’ equity-based pay incentives, empirical research fails to show any correlation between bank CEO equity incentives and bank performance in the Financial Crisis. We offer an alternative analysis, hypothesizing that bank CEOs’ inside debt incentives correlate with reduced bank risk taking and improved bank performance in the Crisis. A nascent literature shows that inside debt may dampen CEOs’ risk taking incentives. Unlike the industrial firms that have been the main focus of this literature, however, banks are subject to pervasive regulatory oversight to constrain risk taking. Therefore, the transmission of risk taking incentives through executive pay structure may not be straightforward and cannot be taken for granted. Nevertheless, we find evidence consistent with our hypotheses. Our empirical evidence provides a rationale for the use of inside debt compensation in structuring executive compensation in the banking context.

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