Tu Nguyen, Sandy Suardi, Jing Zhao
Review of Finance, Volume 29, Issue 4, July 2025, Pages 1259–1302, https://doi.org/10.1093/rof/rfaf026
This study investigates the systemic implications of industry tournament incentives—the external pay disparities among CEOs across similar firms—for financial stability. Motivated by Coles, Li, and Wang (2020), who argue that industry tournament incentives increase managerial risk-seeking behavior, we extend their insight to assess whether these incentives contribute to systemic risk in the financial sector.
Systemic risk refers to the possibility that distress at one financial institution could spill over to the broader financial system, due to the interconnectedness of institutions. Systemic risk can also stem from financial institutions engaging in correlated activities, increasing the likelihood of simultaneous failures. We focus on the U.S. financial industry from 1992 to 2021 and employ the ?CoVaR framework developed by Adrian and Brunnermeier (2016) to capture the cross-sectional tail-dependency and systemic risk accumulation.
Our central finding is that industry tournament incentives—proxied by the pay gap between a firm’s CEO and the second-highest paid CEO in the same industry and size group—are positively associated with an institution’s contribution to systemic risk. This relationship is statistically and economically significant. A one-standard-deviation increase in the external pay gap is associated with a rise in systemic risk contribution, measured at the 95% (99%) confidence level, by 36% (49%) of its mean.
We identify two broad channels through which industry tournament incentives exacerbate systemic risk. First, they are positively associated with the risk of financial institutions in isolation, measured by stock return volatility, Value at Risk, and crash risk. These findings suggest that industry tournament incentives can indirectly contribute to systemic risk due to financial institutions’ interconnectedness.
Second, the external pay gap is positively related to an institution’s financial industry beta and encourages systemically risky activities, suggesting an important and novel impact channel through promoting correlated activities across institutions. Firms with higher industry tournament incentives engage in more non-interest income activities, maintain a lower Tier 1 capital buffer, and have their stock returns strongly correlated with the industry. The mediated effect of industry tournament incentives on systemic risk via this channel is substantial, accounting for 30-50% of the total effect.
This paper contributes to the systemic risk literature by identifying a new determinant—industry tournament incentives—of systemic risk. Our findings underscore the need to consider labor market structures and incentive design when evaluating the sources of financial system fragility.