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The Probability Of Default, Excessive Risk, And Executive Compensation

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Executive Summary

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.

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