Pay-For-Performance Incentives in the Finance Sector and the Financial Crisis

Purpose: An investigation of executive compensation in the finance sector during the periods surrounding the crisis with a view to determining whether compensation incentives were associated with excessive risk taking. Design/methodology/approach: We compare pay-for-performance sensitivity (PFPS) parameters for the finance sector before, during, and after the financial crisis. We also employ the technology sector as a comparison benchmark. Findings: We find that CEO compensation is strongly associated with the accounting-based ROA performance measure in the finance sector particularly in the pre-crisis period; the relationship is amplified in larger firms. In contrast, the technology sector exhibits PFPS only for the market-based stockholder return measure with smaller firms displaying greater sensitivity. Originality/value: From a public policy perspective, it is desirable that PFPS for senior executives in the finance sector is muted. This is due to the risk-shifting incentives specific to the sector whereby profits flow to managers/stockholders while catastrophic losses can be socialized through taxpayer funded bailouts. Our findings imply that compensation practices in the finance sector remain a potential concern for systemic stability. In addition to academics and practitioners, our paper may be of interest to financial regulators. In our opinion they should consider monitoring PFPS in addition to capital ratios, credit default swap spreads, and other metrics in their risk containment strategies