The Probability Of Default, Excessive Risk, And Executive Compensation

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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 113 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 these probabilities using a Heston-Nandi specification and applying 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.