Bank Bonuses and Bailouts

This paper shows that bonus contracts may arise endogenously as a response to agency problems within banks, and analyzes how compensation schemes change in reaction to anticipated bailouts. If there is a risk‐shifting problem, bailout expectations lead to steeper bonus schemes and even more risk taking. If there is an effort problem, the compensation scheme becomes flatter and effort decreases. If both types of agency problems are present, a sufficiently large increase in bailout perceptions makes it optimal for a welfare‐maximizing regulator to impose caps on bank bonuses. In contrast, raising managers' liability can be counterproductive.     

Non-executive compensation in German and Swiss banks before and after the financial crisis

We provide an extensive overview of the determinants of compensation schemes for non-executive employees in the German and Swiss financial services industry. We analyze how pay systems adjust in the aftermath of the financial crisis and find that the crisis had a deep impact on short-term bonus payments. Our results indicate that restrictions on bonus payments may lead to higher fixed salaries and, hence, to a lower performance sensitivity of compensation. We also show that fixed compensation packages are highly standardized between banks, whereas bonus payments are more strongly related to differences between individuals. In Germany, bonuses vary to a higher extent across companies, whereas in Swiss banks, the differences are almost negligible when adding firm controls.     

Executive compensation,risk taking and the state of the economy

In this paper we present a model of executive compensation to analyze the link between incentive compensation and risk taking. Our model takes into account the loss in the value of an executive's expected wealth from employment if the firm becomes insolvent during a bad state of the economy. We illustrate that a given compensation package may lead to different levels of asset risk under different economic states. More specifically, we show that the positive relationship between equity-based compensation and risk taking may weaken and possibly disappear during systemic financial crises. An important policy implication from our analysis is that similar regulations may have different effects on risk taking depending on the state of the economy.     

The executive compensation implications of the tax component of earnings

We extend prior research by examining the weight applied to earnings generated by changes in ETRs (i.e., the tax component of earnings) in determining CEO and CFO compensation. We examine both bonus and total compensation and find that the predicted relationships between compensation and the tax component of earnings are largely limited to bonus compensation. This is not surprising since bonus compensation represents an unambiguous link between contemporaneous performance and compensation, while equity compensation is in part determined by agency considerations. Our evidence suggests that both CEOs and CFOs are compensated for the tax component of earnings. We find that CEOs are rewarded equally for the tax component of earnings relative to other components of earnings, while CFOs are rewarded more for the tax component of earnings relative to other components of earnings. Additionally, the weight applied to the tax component of earnings when determining CFO bonus compensation is greater when; (1) the tax component of earnings does not appear to be related to earnings management; (2) ETRs decrease rather than increase, (3) the firm pays bonus based on after-tax earnings rather than pre-tax earnings, and (4) the firm is tax aggressive rather than non-tax aggressive. The variations in the weighting of the tax component of earnings for CFO bonus compensation noted above in combination with evidence that CEO bonus compensation is indifferent to ETR-related earnings versus other components of earnings, suggests that the tax component of earnings is a contractual component of CFO bonus compensation.     

The association between non-financial performance measures in executive compensation contracts and earnings management

Executive compensation, especially cash bonus compensation, has come under fire by the Securities and Exchange Commission (SEC), the US Federal government, and the media for its role in the current economic crisis. Specifically, the SEC has argued that some compensation packages provide incentives for risk-taking that may undermine shareholder value over the long-term. Short-term incentive payments to executives in the form of cash bonuses are mostly contingent on reaching targets of accounting-related measures or financial performance measures (FPMs). However, the incentives from these payments may lead to accrual manipulation and earnings management (EM). Alternative measures are non-financial performance measures (NFPMs). We expect that firms that employ NFPMs in bonus contracts will have a lower prevalence of EM, since these measures tend to focus executives on the long-term. In this paper, we examine the type of performance measures used by firms in the S&;P 500 index in their cash bonus compensation. We find that firms that use both FPMs and NFPMs have lower discretionary accruals compared to firms that use only FPMs, consistent with lower income-increasing EM. However, we do not find evidence of a reduction in EM behavior using the incidence of meeting or just beating analyst earnings benchmarks, another common EM proxy. In additional tests on a subset of firms with equity offerings, in which incentives for income-increasing manipulation are likely high, we find that firms with NFPMs have lower discretionary accruals. The implication is that NFPMs can be used in compensation contracts to reduce EM behavior and mitigate erroneous executive compensation. This is important to investors as well as regulators, especially in light of the recent debate on compensation reform.     

Earnings Warnings and CEO Welfare

Some CEOs decide voluntarily to issue a warning when they expect a negative earnings surprise. Prior research suggests that warnings contain incremental information beyond actual earnings; warning firms tend to experience permanent earnings decreases. This paper investigates whether compensation committees take warnings into account in setting CEO compensation. We find that warnings are significantly negatively (positively) associated with CEO bonus (option grants), suggesting that compensation committees adjust CEO compensation towards a more high‐powered structure after warnings. However, the sensitivity of bonus or option grants to earnings and stock returns is not affected except for bonus sensitivity to stock returns. We also find weak evidence of an increase in forced CEO turnover after warnings, accompanied by a significant increase in its sensitivity to stock returns. This benefits CEOs with higher ability but imposes more risk on other CEOs. These findings provide a partial explanation of why not every CEO facing a negative surprise decides to issue a warning. Our results are robust to various specifications. In particular, the impact of warnings on compensation appears invariant to the timing or the number of warnings. Overall, these findings suggest that the signal from warnings is used in determining CEO compensation and retention.     

The impact of performance-based compensation on misreporting

This paper examines the effect of CEO compensation contracts on misreporting. We find that the sensitivity of the CEO's option portfolio to stock price is significantly positively related to the propensity to misreport. We do not find that the sensitivity of other components of CEO compensation, i.e., equity, restricted stock, long-term incentive payouts, and salary plus bonus have any significant impact on the propensity to misreport. Relative to other components of compensation, stock options are associated with stronger incentives to misreport because convexity in CEO wealth introduced by stock options limits the downside risk on detection of the misreporting.     

The impact of accounting restatements on CFO turnover and bonus compensation: Does securities litigation matter?

This paper examines the association between accounting restatements, class-action securities litigation and chief financial officer (CFO) turnover and bonus compensation. We identify income-decreasing earnings restatements that were the result of aggressive accounting policies, and hypothesize that these restatements will result in higher CFO turnover rates, and lower bonus compensation, especially when the firm is the target of a restatement-related class-action securities lawsuit. Our results indicate that CFO turnover and bonus compensation are affected by restatements, but only when the restatement firm is the target of a class-action suit. When we expand the analyses to consider other types of executives (e.g., CEOs and COOs), we continue to find that turnover only occurs in the presence of a class-action suit. However, bonus compensation penalties to other types of executives are not limited to litigation-related restatements.     

Changes in bonus contracts in the post-Sarbanes–Oxley era

We examine whether the relation between earnings and bonuses changes after Sarbanes–Oxley. Theory predicts that, as the financial reporting system reduces the discretion allowed managers, firms will put more weight on earnings in compensation contracts to encourage effort. However, the increased risk imposed by Sarbanes–Oxley on executives may cause firms to temper this contracting outcome. We examine and find support for the joint hypothesis that the implementation of Sarbanes–Oxley and related reforms led to a decrease in earnings management and that firms responded by placing more weight on earnings in bonus contracts. We find no evidence that firms changed compensation contracts to compensate executives for assuming more risk.     

Can management-sponsored non-binding remuneration votes shape the executive compensation structure? Evidence from Say-on-Pay votes in Germany

In this paper, a hand-selected sample of 1676 annual general meetings with 268 management-sponsored Say-on-Pay votes in 164 different companies between 2010 and 2015 in the German two-tier system was analysed. The analysis focused on the structure, rather than the level, of executive compensation by applying a sample-selection model and panel data regression. Consistent with our hypotheses, shareholders favour long-term stock and stock option plans but oppose short-term cash-bonus payments. However, the positive effect of equity compensation decreases as the share of the total remuneration increases, suggesting that the alignment effect is limited. The negative effect of bonus payments on the voting results is stronger in cases in which the voting approval of the supervisory board is low. Thus, investors who are discontent with the bonus payments eventually punish the supervisory board in charge of negotiating the contract. The supervisory board reacts to such cases by reducing the bonuses and increasing the equity payments in the following year, but the total compensation or fixed annual salary is unaffected. Hence, Say-on-Pay in Germany affects the structure but not the level of compensation. The results show that shareholders assess the entire compensation structure and prefer a particular compensation mix. However, non-binding Say-on-Pay votes help to establish compensation schemes that are favoured by shareholders.     

Bankers' compensation and fair value accounting

This paper examines the role of certain fair value accounting (FVA) outcomes in compensation of US bank CEOs. The use of FVA in compensation invites an agency cost—the clawback problem—if cash compensation is based on unrealized profits that may reverse in the future. At the same time FVA may be a good measure of current managerial effort and so be cash compensated. We find evidence consistent with a positive link between CEO cash bonus and fair value (FV) valuation of trading assets, managed for short-term profit, as well as (amongst banks with limited trading exposure) a positive link between CEO pay and FV valuations of available for sale (AFS) assets. We find no evidence that trading income is incrementally compensation relevant, indicating that compensation committees avoided the clawback problem for unrealized trading gains. The paper also provides evidence on the link between FVA outcomes and equity-based pay.     

Accounting fundamentals and CEO bonus compensation

Research indicates that there is a positive association between accounting earnings and chief executive officer (CEO) cash compensation; however, evidence also suggests that this positive association ceases to exist when earnings performance is poor or declining. This latter result has led some critics of corporate compensation policies to conclude that CEOs are not penalized for poor or declining firm performance. The purpose of this study is to further illuminate the pay-performance debate by expanding the traditional executive bonus compensation model to include a set of accounting fundamentals that prior research indicates are related to both current and future firm performance. Our results indicate that there is a highly significant relationship between accounting fundamentals and the level of and change in CEO bonus compensation. Moreover, we find a highly significant relationship between accounting fundamentals and both bonus omissions and bonus reductions. When earnings are negative or declining, we find that the above relationships remain intact. In contrast, when earnings are negative or declining, we find that the relationship between aggregate earnings and bonus compensation is weak or insignificant in most of our analyses. Taken together, our results suggest that the apparently weak relationship between accounting earnings and CEO bonus compensation (particularly when earnings are negative or declining) is partly due to the fact that the bonus compensation model excludes accounting fundamentals which are strongly associated with bonus compensation. Thus, we conclude that (i) bonus compensation is more closely tied to firm performance than critics sometimes claim and (ii) bonus compensation awarded to CEOs when earnings performance is poor is at least partially explained by the presence of favorable accounting fundamentals.     

Investment horizon,risk, and compensation in the banking industry

This paper examines the relation between the investment horizon of banks and their CEO compensation, and its consequences for risk and performance. We find that banks with short-term investment intensity pay more cash bonus, exhibit higher risk and perform more poorly than banks with longer-term investment intensity. This evidence is broadly consistent with the view that short-term means of compensation encouraged a short-term investment focus, which in turn led to both higher risk and resulted in poorer performance, culminating in the sub-prime crisis. The inverse risk-performance relation suggests pay schemes were incongruent with shareholders’ interest. Moreover, pay arrangements used in banks prior to the subprime crisis exposed banks to the ex-post settling up problem (the clawback problem).     

The influence of international status and operating segments on firms’ choice of bonus plans

This paper investigates why firms select different accounting measures of performance when determining executive bonus compensation. Specifically, we investigate whether firms with a greater multinational presence and with more operating segments are more likely to use after-tax bonus plans. Newman (1989) investigated the relation between multinational status and bonus plan choice for the mid-1970s and did not find strong results. However, given the increased global implications of business decisions over the last two decades, it should be beneficial to investigate this issue for a more recent time period. We obtained financial information from 266 firms, 70 with after-tax compensation plans, 186 with before-tax compensation plans, and 10 with hybrid compensation plans. Logistic regression analysis suggests that large firms reporting a large number of operating segments and having a high level of multinational operations are more likely to select after-tax rather than before-tax compensation plans.     

Risk-taking in new project selection: Additive effects of bonus incentives and past performance history

The goal of this study is to investigate how past project performance history and bonus incentive pay schemes affect managers' propensity to select more or less risky projects. Performance history is manipulated via past positive outcomes (i.e. beating a target profit rate) and negative outcomes (i.e. missing a target profit rate). Two types of bonus incentive pay schemes (hurdle bonus and graduated bonus) were employed in the study. The findings are consistent with prospect theory that predicts that prior bad outcomes (negative performance history) motivate greater risk-taking than prior good outcomes (positive performance history). In addition, we find evidence that hurdle and graduated bonus incentive schemes also affect risk taking. Overall, we find an additive effect of these two factors, such that the greatest (least) risk taking occurred when participants had negative (positive) prior experience coupled with a graduated (hurdle) bonus scheme.     

CEO Bonus Compensation and Bank Default Risk: Evidence from the U.S. and Europe

We investigate the link between the incentive mechanisms embedded in CEO cash bonuses and the riskiness of banks. For a sample of U.S. and European banks, we employ the Merton distance to default model to show that increases in CEO cash bonuses lower the default risk of a bank. However, we find no evidence of cash bonuses exerting a risk‐reducing effect when banks are financially distressed or when banks operate under weak bank regulatory regimes. Our results link bonus compensation in banking to financial stability and caution that attempts to regulate bonus pay need to tailor CEO incentives to the riskiness of banks and to regulatory regimes.     

Why do managers avoid EPS dilution? Evidence from debt–equity choice

Survey evidence reveals that managers prefer to avoid dilution of earnings per share (EPS), though financial theory suggests it is irrelevant in firm valuation. We explore contracting and behavioral explanations for this apparent paradox using a large sample of debt–equity issuers. We first provide evidence that firms with greater agency conflicts between managers and shareholders are more likely to use EPS as a performance measure in bonus contracts. After controlling for possible endogeneity related to compensation contract design, we find that managers are more likely to avoid earnings dilution when their bonus compensation explicitly depends upon EPS performance. This effect is increasing in the magnitude of bonus compensation for this subset of firms; we document no such associations for the firms that do not use EPS in setting bonus pay. Additional tests of firms’ speed of adjustment to target leverage ratios and firms’ debt conservatism levels indicate that explicitly rewarding executives on EPS performance helps to resolve underleveraging problems. We also find that clientele effects are associated with managers’ aversion to earnings dilution. Our findings provide a deeper understanding of the factors that underlie the use of accounting performance in compensation contracts and new evidence on the implications of the contracting role of accounting in firm decision-making.     

Government's Say-on-pay Policy and Corporate Risk-taking: Evidence from China

This paper investigates whether the restriction on executive compensation in Chinese state-owned enterprises (SOEs) imposed by the Government's say-on-pay schemes is conducive to corporate risk taking. Using a sample of listed SOEs over the period 2005–2018, we find that the restriction on executive compensation is negatively associated with corporate risk taking, suggesting that regulatory intervention in executive pay may produce unintended consequences. Our analyses also demonstrate that this negative regulatory effect on corporate risk taking is driven by listed SOEs in the growth stage of the business life cycle and by those in the provinces with a significant degree of government intervention. An additional test shows that the negative effect of the pay restriction on risk taking disappears in the SOEs in which managers hold shares, suggesting that an alignment of interests between managers and other shareholders mitigates the negative effect of the pay restriction. Our finding is robust to a batch of tests to alleviate the concerns about self-selection and reverse causality.     

CEO compensation and incentives: Evidence from M&A bonuses

We investigate CEO compensation for completing M&A deals. We find that CEOs who have more power to influence board decisions receive significantly larger bonuses. We also find a positive relation between bonus compensation and measures of effort, but not between bonus compensation and deal performance. CEOs with more power also tend to engage in larger deals relative to the size of their own firms, and the market responds more negatively to their acquisition announcements. Our evidence is consistent with the argument that managerial power is the primary driver of M&A bonuses.     

What Drives CEOs to Take on More Risk? Some Evidence from the Laboratory of REITs

Many have pointed to excessive risk‐taking by the CEOs of financial firms as a contributor to the recent worldwide economic crisis. The same observers often blame questionable corporate governance structures and compensation practices for that risk‐taking. But is this perception correct? And what is the relationship between CEO incentives and risk‐taking outside of the financial industry, where the government guarantees provided by deposit insurance could have distorted incentives? In an attempt to answer these questions, the authors analyze the relationship between CEO incentives and corporate risk‐taking by 101 U.S. REITs during the period 2003 to 2007. Their main finding is that corporate risk‐taking, as measured by the growth rate in corporate debt (the only measure of risk that is completely under the control of the CEO), is inversely related to CEO stock ownership—that is, the larger the CEO's equity ownership stake, the slower the growth in debt financing and financial risk‐taking. At the same time, the authors find that financial risk‐taking is positively related to large cash bonuses for the CEOs and to situations in which the CEO is also chairman of the board of directors. Finally, the authors also report that CEOs who are relatively new to the job grow more slowly and borrow less, suggesting that boards of directors can temporarily contain risky expansion plans by the CEO. These results provide support for those corporate governance reformers who wish to cut cash bonus payments for CEOs in favor of long‐term stock ownership.