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E-MailRachel Hayes is Professor of Accounting at the University of Utah David Eccles School of Business; Xiaoli Tian is Associate Professor of Accounting at Georgetown University McDonough School of Business; and Xue Wang is Associate Professor of Accounting at The Ohio State University Fisher College of Business. This post is based on their recent paper, forthcoming in The Accounting Review.
The banking industry has undergone substantial changes since the late 1970s, largely due to deregulation and rapid market developments. Over that period, banks’ growth opportunities expanded, and banks entered new markets, both geographic and product. Motivated by the 2008 financial crisis, researchers and policymakers have shown a renewed interest in corporate governance in the banking industry, with most of the attention focused on the incentives arising from compensation and ownership (e.g., Fahlenbrach and Stulz 2011; Cheng, Hong, and Scheinkman 2015; DeYoung, Peng, and Yan 2013). In particular, several studies attribute changes in the structure of CEO compensation and incentives to the effects of banking deregulation on market opportunities and competition (e.g., Cunat and Guadalupe 2009; DeYoung et al. 2013).
We add to this discussion by examining the interplay between banking deregulation and CEO turnover decisions. Using the staggered adoption of interstate branching laws between 1995 and 1997 as our setting, we investigate whether the performance and risk exposure information used in bank CEO turnover decisions has been affected by the trend towards deregulation in the banking industry. We argue that the examination of measures used in CEO turnover decisions provides unique insights into governance—because directors themselves must make decisions about a CEO’s continued employment, turnover decisions directly reflect board policies. In contrast, most variation in CEO wealth stems from changes in the value of stock and option holdings, so the incentives arising from the CEO’s compensation are partly delegated to the equity markets (Hall and Liebman 1998; Edmans, Gabaix, and Jenter 2017). Furthermore, the board’s management of tensions between financial stability and shareholders’ demand for higher returns is an important aspect of bank governance in the banking deregulation setting. CEO incentives embedded in equity compensation encourage risk taking that might or might not enhance firm value (Bolton, Mehran, and Shapiro 2015; Stulz 2015). In essence, equity compensation is an out-of-the-money call option whose value increases with risk, and may not provide incentives to constrain extreme risk taking. The CEO turnover setting can provide evidence about board policies that mitigate downside tail risk exposure, along with other insights that are not directly evident from examining incentives from CEO compensation and ownership.
We investigate whether banking deregulation affects the weights on performance and risk exposure measures used in bank CEO turnover decisions. Using the difference-in-differences framework, we study how deregulation affects the relation between bank CEO turnover and performance (measured by both earnings and stock returns), as well as the relation between turnover and extreme risk exposure (measured by tail risk). We find that bank CEO turnover is significantly less sensitive to accounting performance in the post-deregulation period. In contrast, bank CEO turnover becomes significantly sensitive to stock return after deregulation. Moreover, we find a positive relation between idiosyncratic tail risk and CEO turnover in the post-deregulation period for banks. The positive relation between bank CEO turnover and idiosyncratic tail risk is consistent with the notion that bank boards use turnover policies to discipline extreme risk-taking activities as the banking industry is deregulated.
We next investigate whether the changes in turnover sensitivities for bank CEOs vary in the cross-section. We find that banks that are better able to take advantage of the growth opportunities associated with the more competitive environment—i.e., large and federally chartered banks—display higher (lower) sensitivity to stock (accounting) performance. The results suggest that competition might have different implications for incentive provision depending on the economic setting, and in particular, on the growth opportunities available.
Our paper adds to the bank CEO turnover literature by examining the sensitivity of CEO turnover to performance and risk exposure in two different market environments—before and after bank deregulation. Because the board of directors evaluates performance and makes decisions about CEO retention, our findings are consistent with bank boards’ historical reliance on earnings shifting to emphasize more forward-looking performance measures when growth opportunities increase. Our results also indicate that bank boards use CEO turnover policies as a disciplinary mechanism to reduce tail risk exposure after deregulation.
While our sample period predates the financial crisis, our results potentially have implications for the debate about whether bank CEO incentives were a factor in the crisis. Our findings suggest that turnover policies reflect both an emphasis on business expansion and a desire to reduce extreme risk taking in the post-deregulation banking environment. Similar to Fahlenbrach and Stulz’s (2011) conclusion that the lack of alignment of bank CEO incentives with shareholder interests cannot be blamed for the financial crisis, we interpret our findings as suggesting that the financial crisis is unlikely to have been driven by incentives for risk taking provided by bank boards through their CEO turnover policies.
The complete paper is available for download here.
