In the search of explanations for the dramatic collapse of the stock market capitalization of much of the banking industry in the U.S. during the credit crisis, one prominent argument is that executives at banks had poor incentives. Rudiger Fahlenbrach and I have completed a working paper titled “Bank CEO incentives and the credit crisis” that investigates how closely the interests of the CEOs of banks were aligned with those of their shareholders before the start of the crisis, whether the alignment of interests between CEOs and shareholders can explain the performance of banks in the cross-section during the credit crisis, and how CEOs fared during the crisis. Traditionally, corporate governance experts and economists since Adam Smith have considered that management’s interests are better aligned with those of shareholders when managers’ compensation increases when shareholders gain and falls when shareholders lose. On average, bank CEOs had powerful incentives to maximize shareholder wealth as of 2006. We show that in our sample the median value of a CEOs equity stake (taking into account options) was $36 million. Typically, a CEO’s equity stake was worth more than ten times his compensation in 2006.
Our results show that there is no evidence that banks with a better alignment of CEOs’ interests with those of their shareholders had higher stock returns during the crisis and some evidence that banks led by CEOs whose interests were better aligned with those of their shareholders had worse stock returns and a worse return on equity. In particular, whether our sample includes investment banks or not, stock return and accounting equity return performance are negatively related to bank CEOs dollar incentives, measured as the dollar change in a CEOs wealth for a 1% change in the stock price. This effect is substantial and is not explained by a few banks where CEOs had extremely high ownership. An increase of one standard deviation in dollar ownership is associated with lower returns of 10.2%. Similarly, a bank’s return on equity in 2008 is negatively related to its CEO’s holdings of shares in 2006 – a one standard deviation increase in dollar ownership is associated with approximately a 10.1% lower return on equity. Though options have been blamed for leading to excessive risk-taking, there is no evidence in our sample that greater sensitivity of CEO pay to stock volatility led to worse stock returns during the credit crisis.
A plausible explanation for these findings is that CEOs focused on the interests of their shareholders in the build-up to the crisis and took actions that they believed the market would welcome. Ex post, these actions were costly to their banks and to themselves when they produced poor results. These poor results were not expected by the CEOs to the extent that they did not reduce or hedge their holdings of shares in anticipation of poor outcomes. Using data on insider trading to estimates sales of shares, we find that CEOs made extremely large losses on their holdings of shares in their bank because they typically did not sell shares. Further, CEOs made large losses on their options.
Our research shows that bank CEOs had very high incentives to maximize shareholder wealth. This evidence makes it implausible that the credit crisis can be blamed on a misalignment of incentives between CEOs and shareholders.