Arif, Salman, Donovan, John, Gopalan, Yadav and MORRIS, ARTHUR and “Pay for Prudence" Journal of Accounting and Economics, Vol. 77, Issue 1, February 2024, 101619.

Abstract

We provide the first evidence that prudential principles shape executive compensation in the banking sector, a phenomenon that we call “pay for prudence” (PfP). We conjecture that PfP helps banks fine-tune executive incentives to balance shareholders’ preference for risk with regulators’ preference for prudence. We detect PfP in the majority of bank compensation contracts, and we find that PfP is positively associated with equity incentives for risk-taking when the PfP terms are detailed and concrete. Analysis of confidential data on bank exams and public data on bank performance suggests that banks that use detailed and concrete PfP are less likely to be downgraded by examiners, have lower tail risk, and have fewer bad loans. Our results shed light on a new dimension of bankers’ pay and suggest that PfP-based incentives complement widely studied equity-based incentives for risk-taking to motivate executives to pursue profitable opportunities.

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