How Does Executive Compensation Affect Bank Risk Taking: Evidence from FAS 123R by Yongqiang Chu, Tao Ma :: SSRN

We examine how executive compensation affects bank risk taking in mortgage lending using exogenous variations in stock option grants generated by the FAS 123R, which requires all firms to expense options. Using a difference-in-differences approach, we find that banks that did not expense options before FAS 123R (treated firms) significantly decreases their approval rates of risky mortgage applications after FAS 123R relative to banks that did not grant stock options or voluntarily expensed their stock option before FAS 123R (control banks). We also find that the treatment effect is concentrated in large banks, suggesting that executives’ risk-taking incentives at large banks are more sensitive to option compensation. This is consistent with the idea that government implicit guarantee on too-big-to-fail banks encourages bank risk-taking. Lastly, we show that treatment banks are more likely than control banks to reduce their exposure to risky mortgage loans through securitization after FAS 123R. Overall, we provide consistent evidence that executive option compensation affects mortgage lending practices in financial institutions, which eventually contributes to the 2008-2009 financial crisis.

via How Does Executive Compensation Affect Bank Risk Taking: Evidence from FAS 123R by Yongqiang Chu, Tao Ma :: SSRN.