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Given the recurring nature and pernicious effects of banking crises, a vast regulatory infrastructure has developed to minimize banks’ likelihood of failure by influencing the types of risks they take. Against this backdrop, HKUST’s Arthur Morris and colleagues shed new light on how to structure executive compensation to balance risk-taking with prudence in the banking sector.

“As part of their oversight,” the researchers explain, “regulators can intervene to curtail activities that maximize shareholder value if these activities also threaten the solvency of the bank.” In response, many banks offer incentives based on prudential regulators’ objectives to reward managers for reducing credit risk. Although minimizing credit risk is a “central objective of bank supervision,” the literature to date has remained silent on prudential compensation incentives.

The researchers sought to fill this gap. “We refer to prudence-based compensation targets as ‘pay for prudence’ (PfP),” they say. “Our study aims to document whether, and to what extent, PfP exists in practice.” It also provides timely evidence of trends in the use of such incentives over time and their association with other incentives for risk-taking and observable measures of bank risk.

“We conjecture that PfP incentivizes bankers to balance shareholders' preference for risk with regulators’ preference for prudence,” the authors explain. To test this hypothesis, they analyze novel data on PfP from the compensation disclosures of publicly traded bank holding companies.

“PfP has grown over time and its usage predates the 2008 financial crisis,” the researchers report. It is positively associated with equity-based incentives for risk-taking, suggesting that it serves as a “guard rail” against managers’ imprudent risk-taking. “PfP is also associated with fewer bad loans, lower tail risk, and fewer regulatory downgrades,” add the authors.

This study provides the first-ever evidence that prudential principles shape banks’ executive compensation contracts, with important implications for risk management in the banking sector.