Incentive compensation, accounting discretion and bank capital

This paper examines the impact of the U.S. banking agencies’ recent guidance on incentive compensation on efforts to have banks build countercyclical capital buffers that can absorb losses during periods of economic weakness. The connection arises from the impact of the compensation guidelines on bank senior managers’ incentives to engage in earnings management. The compensation guidelines for senior managers call for reduced sensitivity of compensation to short-term performance at the higher range of accounting performance, for the deferral of bonus payments over several years with the amount vested reduced for poor accounting performance and the payment of bonuses in equity linked instruments. The results suggest that the parts of the guidance related to accounting earnings based compensation create earnings management incentives that are consistent with countercyclical capital buffers. However, the parts that encourage the payment of compensation in the form of equity-linked instruments may create incentives for senior managers to reduce capital buffers during periods of higher earnings.