Oxford University Paper Addresses Executive Risk-taking

Linking executive pay to credit default swaps (CDSs) are a way to reduce excess risk taking in banks, according to research from Saïd Business School at the UK’s University of Oxford.

The paper, entitled,
’Executive Compensation and Risk Taking’
, depicts how excess risk taking at financial institutions (FIs) affects more than just creditors; extending to depositors, taxpayers, and potentially the financial system as a whole.

The research notes it is generally accepted that giving chief executive officer (CEO) incentives through shares and stock options can encourage excess risk taking. The academic world has recognised this issue over the years and has made several proposals to reduce this; however none of them have been adopted in the real world.

The paper suggests reducing risky behaviour by taking advantage of one of the most significant recent financial innovations: credit default swaps (CDS), which provide a market measure of the risks the bank is exposed to.

The report’s authors – Joel Shapiro, associate professor of finance, Saïd Business School, Oxford, Patrick Bolton , professor of business and professor of economics , Columbia University and Hamid Mehran, assistant vice president (AVP), Federal Reserve Bank of New York – provide a mathematical model of how executives make choices in a financial institution (FI).

They propose that using CDS spreads can be used to lessen risk taking and that incorporating CDS spreads into executive compensation is more effective than deferring compensation. Moreover, they find that shareholders do not have incentives to implement curbs on risk taking, which implies that it may be incumbent on regulatory authorities to do so.

Incorporating a bank’s CDS spread into executive compensation means that more risk taking would then translate into a lower cash bonus.

“In our proposed pay structure for bank CEOs, a high and increasing CDS spread would result in lower compensation, and vice-versa,” said Joel Shapiro. “Our model gives a new insight on risk taking and demonstrates how FIs can provide incentives to reduce risk.”

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