CEO compensation and mortgage origination in the banking industry

• Date: 01 July 2018
• DOI: http://doi.org/10.1111/corg.12244
• Author: Yuanyuan Sun
• Published date: 01 July 2018

ORIGINAL MANUSCRIPT

CEO compensation and mortgage origination in the banking

industry

Yuanyuan Sun

Department of Economics, University of

Illinois at Urbana‐Champaign, 214 David

Kinley Hall, 1407 West Gregory Drive,

Urbana, IL 61801, USA

Correspondence

Yuanyuan Sun, Department of Economics,

University of Illinois at Urbana‐Champaign,

214 David Kinley Hall, 1407 West Gregory

Drive, Urbana, IL 61801, USA

Email: syuanyu2@illinois.edu

Abstract

Manuscript Type: Empirical

Research Question/Issue: This study examines the relationship between bank CEO

compensation and mortgage origination practices before the 2008 financial crisis. It

extends the discussion about the degree of responsibility of executive compensation

for the crisis, by testing whether bank CEO equity incentives contributed to the

growth in high‐risk mortgages before the collapse of the mortgage market.

Research Findings/Insights: Using a unique dataset of comprehensive loan origina-

tion records and CEO compensation in an inclusive sample of publicly traded U.S.

banks, this study finds strong evidence that CEO compensation vega is positively

associated with the riskiness of mortgages before the collapse of the mortgage market

and some evidence that compensation delta is negatively associated with the riskiness

of mortgages.

Theoretical/Academic Implications: This study contributes to the understanding of

the role of executive compensation in the 2008 financial crisis. Consistent with prior

research, it provides further empirical support that compensation vega induces risk‐

taking. Moreover, in the context of the financial industry, the findings illustrate the

potential adverse effect of high‐vega compensation of bank CEOs, as such compensa-

tion may have contributed to the build‐up of high‐risk mortgages prior to the crisis.

Practitioner/Policy Implications: Following the financial crisis, a series of policy

changes towards regulating and reforming executive compensation in financial firms

has been implemented. This study offers important insights for the reform and design

of executive compensation in the financial sector. In particular, practitioners and

policymakers should examine the incentive structures of bank executives (such as

compensation delta and vega) in order to appropriately influence risk‐taking.

KEYWORDS

Corporate Governance, Executive Compensation, Banks, Mortgage Lending, Risk‐taking

1|INTRODUCTION

The subprime mortgage crisis that started in 2007 developed into the

most severe financial crisis in the United States since the Great

Depression. Since then, executive compensation in financial institu-

tions has received intensive scrutiny and is considered an important

factor contributing to the crisis (Blinder, 2009; Conyon, Judge, &

Useem, 2011). According to the Federal Reserve Board (2010a),

flawed compensation practices at banking institutions might have

encouraged excessive risk‐taking. Then Treasury Secretary T im

Geithner also recognized that “this financial crisis had many significant

causes, but executive compensation practices were a contributing

Received: 21 October 2016 Revised: 22 May 2018 Accepted: 25 May 2018

DOI: 10.1111/corg.12244

Corp Govern Int Rev. 2018;26:273–292. © 2018 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/corg 273

factor”(Department of the Treasury, 2009a). As a result, the Treasury

issued a series of guidance regarding executive compensation for

the financial institutions that received government aid after 2009

(Department of theTreasury, 2009b). In 2010, several bank regulatory

agencies including the Federal Reserve Board, the Office of the Comp-

troller of the Currency (OCC), the Office of Thrift Supervision (OTS),

and the Federal Deposit Insurance Corporation (FDIC) jointly issued

the final guidance on incentive compensation at financial institutions

(Federal Reserve Board, 2010b). The Dodd–Frank financial reform leg-

islation also has provisions that specifically regulate executive com-

pensation and corporate governance in financial firms. An implicit

belief underlying these policy changes is that executive compensation

at financial institutions is misaligned with shareholder value and

encourages excessive risk‐taking.

This study contributes to the debate regarding the degree of

responsibility of executive compensation for the crisis, by testing

whether bank CEO equity incentives contributed to the growth in

high‐risk mortgages before the collapse of the mortgage market, one

of the key hypotheses underpinning these regulatory policy changes.

Since the financial crisis, numerous studies have examined the role

of banks' corporate governance and executive compensation in con-

tributing to the crisis both in the United States (e.g., Balachandran,

Kogut, & Harnal, 2011; Cheng, Hong, & Scheinkman, 2015; DeYoung,

Peng, & Yan, 2013; Ellul & Yerramilli, 2013; Fahlenbrach & Stulz,

2011; Grove, Patelli, Victoravich, & Xu, 2011; Mehran, Morrison, &

Shapiro, 2011; Muller‐Kahle & Lewellyn, 2011) and internationally

(e.g., Beltratti & Stulz, 2012; Erkens, Hung, & Matos, 2012; Laeven &

Levine, 2009; Yeh, Chung, & Liu, 2011). (For a comprehensive review

of corporate governance in banks, see John, De Masi, & Paci, 2016.) In

particular, studies that examined executive compensation in financial

firms in the U.S. have focused on the effect of incentive compensa-

tion, especially equity compensation. Some consensus has emerged

that the equity compensation of bank executives, especially stock

option compensation, is associated with a higher level of risk‐taking.

For example, Balachandran et al. (2011) found that the proportion of

equity‐based incentives increases the probability of default, and

DeYoung et al. (2013) showed that a compensation structure with

high‐vega leads to riskier business policies. In addition, Mehran et al.

(2011) showed that the vesting schedules of top executives in banks

shortened in 1996–2007, which may have encouraged executives'

short‐term orientation. Moreover, Fahlenbrach and Stulz (2011) found

that CEOs whose incentives were better aligned with shareholders,

represented by higher pay‐for‐performance sensitivities, experienced

poorer bank performance during the crisis.

This study extends existing research by using measures that

directly characterize the riskiness of mortgages originated by banks.

It is known that the subprime mortgage crisis started in the mortgage

market, and the origination of high‐risk mortgage loans is one of the

root causes of the collapse of the mortgage market; therefore, an

examination of banks' mortgage lending practices that relate to

mortgage quality would be particularly pertinent. Previous studies

have adopted various risk‐taking measures such as stock market risks

measured by stock return volatility (Cheng et al., 2015; Mehran &

Rosenberg, 2008), risky business models or corporate policies

(DeYoung et al., 2013; Mehran & Rosenberg, 2008), and loan quality

of the subprime mortgages measured by subsequent loan delinquency

(Keys, Mukherjee, Seru, & Vig, 2009). Stock return volatility is a widely

used measure of a firm's risk‐taking, but it measures ex post realized

risk that incorporates various aspects other than executives' intentions

or actions; for example, it may also incorporate market speculation

activity (Bolton, Scheinkman, & Xiong, 2006). Therefore, it cannot

accurately capture executives' intentions or actions, or the ex ante

risk‐taking incentives that bank executives have. The risky business

models or corporate policies used in DeYoung et al. (2013) and

Mehran and Rosenberg (2008) more concretely capture bank

executives' actions. For example, DeYoung et al. (2013) used private

mortgage securitization and fee‐generating non‐interest activities to

represent risky business models; Mehran and Rosenberg (2008) used

three key corporate policies to measure risk‐taking, which includes

investment choice, amount of borrowing, and level of capital. How-

ever, these measures do not directly capture the riskiness of banks'

mortgage origination. The study by Keys et al. (2009) that examined

the influence of financial regulation and securitization, used subse-

quent loan delinquency to measure the loan quality, which, so far, is

the only study (that we know of) utilizing loan quality to capture

risk‐taking. However, our study differs from Keys et al. (2009) in mul-

tiple aspects. First, their study presented evidence regarding the effect

of bank CEOs' total compensation, in contrast to that of risk managers'

compensation, on the quality of loans; whereas our study focuses

solely on CEO compensation and, in particular, equity incentives

rather than total compensation. Keys et al. (2009) also focused on

subprime mortgages and used a relatively small sample of 37 lenders

from 2001 to 2006, whereas this study utilizes all of the documented

mortgage origination records of over 400 banks from 2000 to 2006.

This study closely follows DeYoung et al. (2013) in exploring the

effect of CEO equity incentives (as measured by delta and vega) on

banks' business practices. The present study, by directly capturing the

riskiness of banks' mortgage portfolios, further complements the

existing evidence on this subject in the context of the pre‐crisis era

when the risks were being built up. The main measures that characterize

the riskiness of mortgages used in this study include loan‐to‐income

ratio and the percentage of higher‐priced loans, which have rarely been

used in existing studies. In order to fully capture the changes in the

distribution of the risk profile of the mortgages, this study examines

not only the means and medians but also the percentiles of the

loan‐to‐income ratios of all of the mortgages originated by a bank.

The above analysis was enabled by the construction of a unique

dataset of comprehensive mortgage origination records using the data

collection authorized by the Home Mortgage Disclosure Act (HMDA)

dataset, which is one important contribution of this study. We used

the loan origination records in the HMDA data and aggregated over

11 million home purchase loans originated by the sample banks at the

level of each bank and then at the level of each bank's top holder; by

doing so,we were able to link all of the mortgageoriginationsof a bank's

top holder to its organizational‐level characteristics, such as executive

compensationcontracts. Analyzing mortgage origination practices using

aggregatedmortgageorigination data atthe level of the bank's topholder

has been rare. Most existing studies using the HMDA data to examine

the mortgagemarket priorto the financial crisis,such as Dell'Ariccia,Igan,

and Laeven(2012), have conducted analysis at the loan level.

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