Incentive Features in CEO Compensation: The Role of Regulation and Monitored Debt

Abstract

We study CEO compensation in the banking industry by taking into account banks’ unique claim structure in the presence of two types of agency problems: the standard managerial agency problem as well as the risk-shifting problem between shareholders and debtholders. We empirically test two hypotheses derived from this framework: (1) the pay-for-performance sensitivity of bank CEO compensation decreases with the total leverage ratio; and (2) the pay-for- performance sensitivity of bank CEO compensation increases with the intensity of monitoring provided by regulators and nondepository (subordinated) debtholders. We construct an index of the intensity of outsider monitoring based on four variables: subordinated debt ratio, subordinated debt rating, non performing loan ratio and BOPEC rating assigned by regulators. We find supporting evidence for both hypotheses. Our results hold after controlling for the endogeneity among compensation, leverage and monitoring. They are robust to various regression specifications and sample criteria.