Executive Compensation and Credit Spread

Topic and Objectives

ln the aftermath of the recent financial crisis there has been increasing debate over the role of managerial compensation. Analysts and critics argue that many compensation packages may have generated excessive risk taking and contributed to the rapid spread of the crisis. ln this paper, we analyze the risk taking incentives of a manager whose compensation package consists of salary, equity awards and inside debt. Salary is the fixed component of pay, independent of performances. Equity compensation increases with stock prices and, thus, depends on performance. Inside debt consists of pensions and deferred compensation plans, whose payment is delayed until the retirement date. For tax-deferral benefits, inside debt is often unsecured, unfunded, and subject to a substantial risk of forfeiture in bankruptcy.

Key Findings

• We show that inside debt only exerts the beneficiaI effect that is traditionally attributed to it as a tool to reduce risk-taking incentives if its risk of forfeiture in bankruptcy is high.
• We derive conditions under which inside debt increases managerial risk-taking incentives and accelerates the process towards bankruptcy. For instance, a large and unsecured inside debt tends to distort the risk-taking incentives of equity compensation and generates a situation in which higher equity ownership Ieads to higher credit spreads.