Bruce Kogut

The Probability of Default, Excessive Risk, and Executive Compensation: A Study of Financial Services Firms from 1995 to 2008

Coauthor(s): Hitesh Harnal. View Publication

Abstract:
The financial crisis of 2008 has many causes, with the role of executive compensation in creating excessive risk taking being frequently cited in the press and by policy makers as a leading candidate. 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. The results are robust across all specifications estimated.

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