CEO Incentives and Bank Risk over the Business Cycle

We examine whether the relationship between managerial risk-taking incentives and bank risk is sensitive to the underlying macroeconomic conditions. We find that risk-taking incentives provided to bank executives are associated with higher bank riskiness during economic downturns. We attribute this finding to the increase in moral hazard during macroeconomic downturns when the perceived probability of future bailouts and government guarantees rises. This association is particularly strong for larger banks, banks that maintain lower capital ratios and banks that are managed by more powerful CEOs. Our findings highlight the importance of the interaction between managerial incentives and the macroeconomic environment. Boards and regulators may find it useful to consider the countercyclical nature of the relationship between risk-taking incentives and bank riskiness when designing managerial compensation.