Corporate Governance, Bank Mergers and Executive Compensation

• Author: Carol Padgett,Simone Varotto,Yan Liu
• Published date: 01 January 2017
• DOI: http://doi.org/10.1002/ijfe.1565
• Date: 01 January 2017

CORPORATE GOVERNANCE, BANK MERGERS AND EXECUTIVE

COMPENSATION

YAN LIU, CAROL PADGETT

,

*

,†

and SIMONE VAROTTO

ICMA Centre, Henley Business School, UK

ABSTRACT

Using a sample of US bank mergers from 1995 to 2012, we observe that the pre-post merger changes in CEO bonus are signif-

icantly negatively related to the strength of corporate governance within the bidding bank. This suggests that bonus compensa-

tion is not consistent with the ‘optimal contracting hypothesis’. Salary changes, on the other hand, are not affected by corporate

governance which is in line with ‘optimal contracting’. We also find that good governance is associated with more accretive

deals for the bidder. Overall, our results are consistent with the notion that, unlike salary and long-term compensation, bonus

compensation is not aligned with value creation and is more vulnerable to CEO manipulation in banks with poor corporate gov-

ernance. Copyright © 2016 John Wiley & Sons, Ltd.

Received 08 December 2015; Revised 22 August 2016; Accepted 11 September 2016

JEL CODE: G21; G28; G34

KEY WORDS: corporate governance; bank mergers; executive compensation; bonus

1. INTRODUCTION

The level of CEO compensation and its relationship with performance have been controversial topics following the

recent financial crisis. Views diverge on the efficacy of compensation contracts in maximizing firm value and con-

taining risk taking. Compensation in the financial industry, especially the large bonus packages paid to CEOs of

underperforming banks, has attracted mounting criticism. As a result, from the beginning of 2014, the European

Union has placed a cap on bankers’bonuses.

1

CEO compensation that engenders excessive risk taking and weak

corporate governance more generally has been cited as an important cause of the financial crisis by the OECD

(Kirkpatrick, 2009). Against this backdrop, it is surprising that little academic research has looked at the link be-

tween CEO compensation and corporate governance in the banking industry. In this paper, we provide evidence

of the effects of corporate governance on CEO compensation in the context of bank mergers. Mergers provide a

suitable laboratory to study CEO compensation as they are often accompanied by significant changes in firm val-

uation, performance and risk. The academic literature has found evidence of significantly higher levels of CEO

compensation after M&A deals.

2

In this study, we focus on the ‘optimal contracting hypothesis’in which CEO

interests are assumed to be aligned with those of shareholders (see, for example, Core et al., 1999). Optimal

contracting leads to CEO compensation that is positively and significantly related to firm value, and unrelated to

the strength of corporate governance within the firm. This is because optimal contracting resolves the agency prob-

lem between CEO and shareholders and hence makes the heightened monitoring effected by good governance

irrelevant. For our analysis, we use Thomson One Banker to source 214 domestic bank mergers in the US

announced between 1995 and 2012. We look at the US because it is one of the most active markets for corporate

*Correspondence to: Carol Padgett, ICMA Centre, Henley Business School, University of Reading, Whiteknights, Reading, RG6 6BA, UK.

E-mail: c.padgett@icmacentre.ac.uk

1

The cap is 200% of salary. See Jill Treanor, European banks to get new guidelines on bonus cap and ‘allowances’, 13 June 2014, The

Guardian.

2

See, for example, Bliss and Rosen (2001) and Anderson et al. (2004).

Copyright © 2016 John Wiley & Sons, Ltd.

International Journal of Finance & Economics

Int. J. Fin. Econ. 22:12–29 (2017)

Published online 4 November 2016 in Wiley Online Library

(wileyonlinelibrary.com). DOI: 10.1002/ijfe.1565

control. It has also been the epicentre of the Great Recession of 2007–2009 which has led to an international agree-

ment on compensation guidelines, together with national legislation, to constrain short termism and risk taking in

banks.

3

Our work contributes to the literature in the following ways. First, as far as we are aware, this is the first paper

that examines how corporate governance affects CEO compensation around bank mergers. While previous studies

have looked at industry diversified samples (e.g. Grinstein and Hribar, 2004 and Harford and Li, 2007), we con-

centrate on banks because of the distortions that compensation policies can produce on bank behaviour and the

resulting impact on financial stability.

4

Second, we show that the optimal contracting hypothesis can be accepted

or rejected depending on the components of CEO compensation it is tested on, namely, salary, bonus or long-term

compensation. We find that while salary satisfies optimal contracting, the bonus component is significantly reduced

by the strength of corporate governance which provides evidence against the null. This suggests that bonus com-

pensation is not necessarily related to firm value creation. On the other hand, changes in long-term compensation

around mergers have a distinct behaviour that differs from that of salary and bonus. Indeed, long-term rewards do

not appear to be explained in any meaningful way by governance or performance variables. Third, we introduce a

new index (CGI) to measure the strength of corporate governance. The index is purpose-built with hand collected

data from company filings and considers 11 key drivers of good governance including board composition, CEO

power, antitakeover measures, ownership concentration and legal environment.

5

Fourth, we provide evidence that

the risk dimension is a crucial determinant of CEO compensation. Both changes in salary and bonus are negatively

related to the risk taken by the bidding bank’s CEO, measured as the bidder’s stock price volatility around a

merger. Moreover, when looking at banks that sought government support during the recent subprime crisis, we

find that boards penalize higher risk taking by reducing CEO salary. However, although bonus changes were lower

in banks that required government funding, the banks’risk taking does not appear to have influenced bonus

compensation.

In line with previous literature (Masulis et al., 2007; Hagendorff et al., 2007, 2010), we also find that corporate

governance is an important value driver for bidder abnormal returns, after controlling for other firm and deal-

related characteristics. For example, our governance index alone can explain up to 6.8% of the variations in

bidders’abnormal return around merger announcements. This suggests that good governance may lead to higher

shareholder value.

This paper proceeds as follows. In Section 2, we review relevant literature. We describe our data and the com-

position of the corporate governance index (CGI) in Sections 3 and 4. In Section 5, we describe our regression

model. Sections 6 and 7 summarize our main findings and robustness tests. Section 8 concludes the paper.

2. LITERATURE REVIEW

Our research is related to a strand of the literature that examines the effects of corporate governance on CEO

compensation. Hallock (1997) finds that interlocking directorships significantly increase CEO compensation.

3

In 2009, the Financial Stability Board (FSB) introduced principles of sound compensation practices that are ‘aligned with long-term value cre-

ation and prudent risk-taking’. The principles further state that ‘[f]or senior executives as well as other employees whose actions have a material

impact on the risk exposure of the firm: (i) a substantial proportion of compensation should be variable …(ii) a substantial portion of variable

compensation, such as 40 to 60%, should be payable under deferral arrangements over a period of years; (iii) these proportions should increase

significantly along with the level of seniority and/or responsibility.’Further, ‘Subdued or negative financial performance of the firm should gen-

erally lead to a considerable contraction of the firm’s total variable compensation, taking into account both current compensation and reductions

in payouts of amounts previously earned, including through malus or clawback arrangements.’Theimplementation of these principles has been

undertaken by the Basel Committee on Banking Supervision (see BCBS (2010)), the International Association ofInsurance Supervisors (IAIS)

and the International Organization of Securities Commissions (IOSCO). Similar principles have been embedded in the Dodd-Frank Act that was

signed into law in the United States in 2010.

4

Federal Reserve Chairman Ben S. Bernanke stated that ‘Compensation practices at some banking organizations have led to misaligned incen-

tives and excessive risk-taking, contributing to bank losses and financial instability’. (press release October 22, 2009, Board of Governors of the

Federal Reserve System)

5

Our approach is consistent with Jensen and Meckling (1976) and Shleifer and Vishny (1997), who see corporate governance as a way to mit-

igate agency problems which arise from the separation of ownership and control. We are aware of an even broader perspective of corporate gov-

ernance which involves a greater spectrum of stakeholders, such as depositors, employees, suppliers, society as a whole, etc. However, for the

purpose of this study, we focus on corporate governance as a means to solve the agency problems between shareholders and managers.

CORPORATE GOVERNANCE, BANK MERGERS AND EXECUTIVE COMPENSATION 13

Copyright © 2016 John Wiley & Sons, Ltd. Int. J. Fin. Econ. 22:12–29 (2017)

DOI: 10.1002/ijfe