The effect of executive compensation on extreme risk is frequently cited as a leading candidate for the financial crisis. The evidence for or against is scarce. This paper assembles panel data on 117 financial firms from 1995 through 2008, using the financial crisis as a type of "stress test" experiment to determine the relation of equity-based incentives on the probability of default. After estimating default probabilities using a Heston-Nandi specification, we apply a dynamic panel model to estimate statistically the effect of compensation on default risk. The results indicate uniformly that equity-based pay (i.e. restricted stock and options) increases the probability of default, while non-equity pay (i.e. cash bonuses) decreases it.
Balachandran, Sudhakar, Bruce Kogut, and Hitesh Harnal. "Did Executive Compensation Encourage Extreme Risk-taking in Financial Institutions?" Working Paper, Columbia Business School, April 2011.
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