Study reveals link between bank bosses’ pay and risk-taking

Banks whose chief executives receive substantial bonuses for completing acquisitions are more likely to carry out risky takeovers and mergers, analysis of US bank acquisitions from 1993-2007 shows.

Consequently, the amount of risk taken on by banks – a major factor in the ongoing credit crunch – is a direct result of the amount of incentives given to banking executives.

The analysis was put together by researchers at Edinburgh University Business School and co-written by colleagues at Leeds University.

As the link between executive pay and bank risk encourages financial volatility, regulators should consider limiting the incentives, such as stock options, that bankers receive, the researchers claim.

Jens Hagendorff, senior lecturer at Edinburgh University Business School, said: “Chief executive pay in banking is much more geared towards rewarding risk-taking than in any other industry. Our research shows that banking chief executives are clearly responsive to the risk-taking incentives they receive.

“Since concerns over financial stability are one of the main reasons for regulating banking, the links between risk-taking and chief executive pay support the case for regulating compensation in the banking industry.”

Researchers found that during the 1993-2007 period studied, chief executives were offered increasingly large amounts of risk-based compensation. They also found that banks whose chief executives received higher incentives engaged in riskier behaviour than they had previously.

Francesco Vallascas, lecturer in banking and finance at Leeds University Business School, added: “With parts of the world still reeling from the sub-prime crisis, executive pay in the banking industry is more contentious than ever.

“But our results show a clear link between executive pay and risky behaviour in banks. Regulating bankers’ pay is an issue that deserves consideration, no matter how controversial it is.”

The paper is published in the Journal of Corporate Finance. It is available at http://dx.doi.org/ 10.1016/j.jcorpfin.2011.04.009.