Since before the financial crisis, excess risk-taking at highly levered financial institutions has been a large concern. Defaults by such institutions affects more than just creditors; it affects depositors,
taxpayers, and potentially the financial system as a whole.
It is well known that giving Chief Executive Officer (CEO) incentives through shares and stock options can encourage excess risk taking. We propose tying a CEO’s compensation in part to the financial firm’s credit default swap (CDS) spread, which provides a market estimate of the default risk of the financial institution. In our proposed pay structure for bank CEOs, a high and increasing CDS spread would result in lower compensation, and vice-versa. By giving executives a stake in both the upside and downside for the firm, we can provide incentives to engage in a prudent amount of risk taking.
We further demonstrate that while compensation based on both the stock price and CDS spread reduces excess risk taking, shareholders may not be able to commit to design such contracts. Moreover, shareholders may not want to use such contracts due to distortions from deposit insurance or unobservable tail risk. This means that regulators need to play a role in order to implement these compensation contracts.
Just like the stock price, the CDS spread is determined by a market. The CDS of major financial institutions are traded frequently. The spread can thus react quickly to new information. This has two key benefits. First, incorporating CDS spreads into compensation packages can be fairly easy to
implement. Second, the discipline of the market reduces the difficult monitoring role that regulators face in determining whether a financial institution is overstepping its bounds and how to deal with it.
A similar way to reduce risk taking incentives that has been discussed is to use actual debt or “inside debt” in CEOs’ compensation packages. Inside debt is compensation that has debt-like characteristics, such as deferred compensation or pension benefits, both of which could disappear if the firm went bankrupt. The value of debt decreases when there is a larger risk of bankruptcy; therefore if the CEO is compensated with some type of debt, she would have the incentive to take less risk. While this approach moves in the right direction, we demonstrate in our paper that using CDS spreads are better. The reason is that using something that is easily traded and has a market price gives the transparency needed to provide the correct incentives.
One side-benefit of our approach is that it creates a built-in stabilizer using compensation that would have been useful in the crisis. When banks’ performance deteriorates and their credit quality weakens (and they experience an increase in their CDS spread), the banks will be forced to conserve capital through the automatic adjustment of bonuses. Our approach is thus in a sense analogous to cutting dividends to protect the bank and its creditors. While cutting dividends imposes a cost on all shareholders, our approach imposes a direct cost on risk-taking managers as well.