Regulation, subordinated debt, and incentive features of CEO compensation in the banking industry

We study CEO compensation in the banking industry by considering banks’ unique claim structure in the presence of two types of agency problems: the standard managerial agency problem and the risk-shifting problem between shareholders and debtholders. We empirically test two hypotheses derived from this framework: that the pay-for-performance sensitivity of bank CEO compensation (1) decreases with the total leverage ratio and (2) 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: the subordinated debt ratio, subordinated debt rating, nonperforming loan ratio, and BOPEC rating (regulators’ assessment of a bank’s overall health and financial condition). 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.