Executive Stock Options and Systemic Risk

Banks’ role in financial intermediation and the provision of other specialized financial services not only places them at the center of many important global financial markets, but also ties their health to that of other financial institutions, industrial firms, and consumers. The vast reach of banks’ activities was made apparent during the financial crisis of 2007-2009, which also highlighted the acute need for a better understanding of whether, how, and the extent to which banks contribute to systemic risk in the economy (i.e., the risk that many financial institutions fail together). Prior research into the sources of systemic risk largely focuses on the outcomes of banks’ risky activities (e.g., the composition of banks’ financing or the correlation of banks’ asset returns). However, these and other risky activities are ultimately the result of bank managers’ decisions which, we argue, are shaped by their contractual incentives. Following this intuition, we study whether and how bank executives’ compensation contracts lead to the systemic risk of their institutions.

We do so by focusing on bank executives’ equity portfolio (i.e., stock and option) “vega,” which captures the sensitivity of their equity portfolio’s value to their firm’s stock return volatility. We expect to find a positive relationship because the highly levered nature of banks’ capital structure should encourage the pursuit of activities that could entail systemic risk. In addition, compensation contracts enhance strategic complementarities in bank risk-taking; that is, one bank’s increased risk encourages other banks to do likewise, thereby increasing the overall systemic risk in the industry.

We first examine the relation between bank managers’ risk-taking equity incentives and two common, market-based measures of systemic risk: (i) marginal expected shortfall, MES; and (ii) D CoVaR, both of which capture the correlation between an individual bank’s stock return and that of the banking system as a whole. Using a sample of commercial banks during the time period 1995-2016, we find no evidence of a relation between the equity portfolio vega of senior bank executives and the one-, two-, and three-year-ahead systemic risk of their banks after adjusting for the endogenous relation between the two (e.g., bank executives who are more tolerant of—and also inherently prone to take—systemic risk tend to work at, or “assertively match with,” inherently riskier banks).

Next, we examine whether there is a differential effect of vega on systemic risk during economic expansions and contractions. We find no evidence of a relation between vega and subsequent systemic risk during expansions, but do find evidence of a positive relation between the two during contractions. These findings suggest that the effects of equity risk-taking incentives on systemic risk only manifest during economic contractions.

Finally, we investigate specific activities that potentially contribute to banks’ exposure to and accretion of systemic risk. On the liability and equity side of the balance sheet, we find that vega leads to a greater reliance on short-term deposits and lower common equity Tier 1 ratios. Banks with more short-term debt and less equity capital are more susceptible to liquidity shocks and prone to runs during economic downturns, both of which can contribute to systemic risk.

On the asset side of the balance sheet, we find that vega encourages bank managers to (i) extend a greater proportion of commercial and industrial loans in their loan portfolio, (ii) hold a greater proportion of non-agency mortgage-backed securities in their available-for-sale investment portfolio, and (iii) extend more lines of credit out of their total lending activities (but at lower rates). These lending and investment activities are highly procyclical and can generate significant losses during economic contractions, which can lead to systemic risk. We corroborate this intuition by showing that these specific activities do, in fact, contribute to banks’ subsequently realized risk during economic contractions.

Our paper contributes to our understanding of the drivers of systemic risk. Although prior research identifies certain bank characteristics that are associated with their systemic risk, the contractual incentives of the executives whose decisions are ultimately responsible for influencing those characteristics have received considerably less attention as a potential cause of systemic risk. By adopting a novel econometric approach, we provide more credible evidence that bank managers’ equity portfolio vega causes them to increase the systemic risk of their institutions and encourages activities that are arguably a source of the buildup of systemic risk.

Our findings also have broader implications. Bank executives’ compensation contracts have attracted significant attention and scrutiny from regulators, legislators, investors, governance activists, and a variety of other stakeholders. Section 956 of the Dodd-Frank Act, which is arguably one of its centerpieces, instructs bank regulators to draft regulations that restrict certain executive compensation practices that are thought to encourage excessive risk-taking. Our evidence that bank executives’ contractual incentives encourage systemically risky activities suggests that these and other regulations at the microprudential level (e.g., those promulgated under Section 956 of the Dodd-Frank Act) may be one way to influence macroprudential (e.g., systemic) risk. Thus, although directly controlling systemic risk per se is not typically the stated goal of microprudential regulation, our evidence suggests that it can be an indirect effect of regulating bank executives’ compensation contracts.

The complete paper is available for download here.