Impact of compensation structure and managerial incentives on bank risk taking

In this article, we analyze the impact of managerial compensation structure in publicly-traded banks on their risk taking behavior described by the loans extended by them, and the changes in risk taking through the changing regulatory environment for these banks. We build a simulation model to study the impact of the interaction between regulatory changes and competitiveness in the sector on managerial compensation, and in turn their joint impact on a bank’s riskiness. Utilizing the simulation model, we will test the following three hypotheses, 1) increase in competitiveness after deregulation results in higher levels of risk for banks, 2) regulatory changes can result in change in the composition of managerial compensation, which creates an environment of incentives for enhanced risk taking, 3) regulatory changes accompanied by certain governance or managerial compensation controls can bring prudence in the risk taking behavior. A broad range of data from financial, managerial, competition and governance is obtained for periods of 15-20 years from the call reports of the Federal Reserve Bank of Chicago, ExecuComp and the IRRC databases to calibrate the simulation model and analyze the above three hypothesis. Utilizing the simulation model, we achieve isolating the role of changing competition and compensation triggered by regulatory changes as sources of potential changes in bank’s riskiness, and the extent of impact on a sample of different banks. The extent of impact is then correlated with the governance characteristics of the banks. We observe that competition uniformly increases the risk in firm value and shareholder-equity of all the banks, more severely for some than others. Its effect on change of firm value through regulatory changes observed is opposite from its effect on shareholder-equity for some banks. Change in competition combined with change in managerial compensation captures significantly more of the increased risk in firm value and shareholder-equity. Lastly, the governance characteristics show that risk differential between competition alone and competition combined with compensation is low for banks with good governance.