Bankers on the Board and CEO Incentives
DOI | http://doi.org/10.1111/eufm.12101 |
Author | Andy (Y. Han) Kim,Min Jung Kang |
Date | 01 March 2017 |
Published date | 01 March 2017 |
Bankers on the Board and
CEO Incentives
1
Min Jung Kang
University of Michigan–Flint, 2138 Riverfront Center, 303 E. Kearsley Street, Flint, MI 48502, USA
E-mail: kangmin@umflint.edu
Andy (Y. Han) Kim
SungKyunKwan University (SKKU), Room 524, Business School Building, SungKyunKwan University,
Jongno-gu, Seoul, Korea, 110-746
E-mail: ayhkim@skku.edu
ABSTRACT
The Sarbanes-Oxley Act demanded the presence of more financial experts on
corporate boards to improve governance. Directors from lending banks require
particular attention because of the conflicts of interest between shareholders and
debtholders despite their financial expertise. In this paper, we examine whether
commercial banker directors work in the best interests of shareholders in
providing incentives to the CEO. We find that the CEO’s compensation VEGA is
lower if an affiliated banker director is on the board. Further, we find that
1
The first author, Min Jung Kang is Assistant Professor of Finance at the University of
Michigan-Flint. Part of this paper comes from the first chapter of her doctoral dissertation
at Michigan State University. Andy Kim is an Associate Professor of Finance at
SungKyunKwan University. Special thanks are due to G. Geoffrey Booth and Jun- Koo
Kang, who gave the authors great support and encouragement. The authors also thank John
Doukas and two anonymous referees for great comments to help improve the quality of the
paper. They also thank the seminar participants at the SKKU–Peking University Forum; the
Korean Securities Association seminar; California State University, San Bernardino;
Hofstra University; Korea University; Menlo College; Michigan State University; Seoul
National University; SKKU; an d the University of Michigan-Fl int. For insightful
comments, the authors thank Joon Chae, Sungwook Cho, Henrik Cronqvist, Mara Faccio,
C. Edward Fee, Gustavo Grullon, Charles J. Hadlock, Jarrad Harford, Gerard Hoberg, Cliff
Holderness, Mark Huson, Dirk Jenter, Li Jin, Dong-Soon Kim, Joong Hyuk Kim,
Jungwook Kim, Noolee Kim, Woo Chan Kim, Woojin Kim, Ron Masulis, Michael
Mazzeo, William L. Megginson, Hyun Seung Na, Kwang Woo Park, Sheridan Titman, Fei
Xie and JunYang, and Dirk Jenter for graciously sharing the CEO turnover data for 1993–
2001. The authors also appreciate Moody’s KMV for providing the expected default
frequency data for our sample firms. Andy Kim is grateful to the Sungkyun Research Fund,
Sungkyunkwan University, 2015, and the excellent research assistance of Youngjae Jay
Choi, Brian He, Denise Heng, Joyce Tan and Alvin Wei. All errors are those of the authors.
European Financial Management, Vol. 23, No. 2, 2017, 292–324
doi: 10.1111/eufm.12101
© 2016 John Wiley & Sons, Ltd.
commercial banker directors increase debt-like compensation (Sundaram and
Yermack, 2007) and make it less sensitive to risk.
Keywords: bankers on board, financial expertise, conflicts of interest, governance,
board of directors, CEO compensation
JEL classification: G14
1. Introduction
Boards of directors play an important role in monitoring and advising chief executive
officers (CEOs) in the interests of shareholders (Fama and Jensen, 1983; Hermalin and
Weisbach, 1988, 1998; Jensen, 1993; Adams et al., 2008). However, the boards of
directors may not always act in the best interests of the shareholders (Bebchuk and Fried,
2003). In fact, US non-shareholder constituency statutes (or stakeholder statutes) allow
directors to consider the effects on non-shareholder stakeholders when making board
decisions (Adams and Ferreira, 2007), suggesting that directors’preferences could
diverge from those of the shareholders, depending on the director’s background.
Among the many different backgrounds of boards of directors, commercial banker
directors (CBDs) deserve special attention due to their financial expertise and potential
conflicts of interest between shareholders and debtholders (Jensen and Meckling, 1976;
Booth and Deli, 1999; Kroszner and Strahan, 2001; G€
uner et al., 2008; Sisli-Ciamarra,
2012; Hilscher and Sisli-Ciamarra, 2013). A CBD is defined as an outside director in a
non-financial firm who is also an executive of a commercial bank. The bank may or may
not have loan exposure to the firm. Because one needs to have adequate expert
knowledge and an extensive professional network in financial markets to be promoted as
a bank executive, a CBD is assumed to have financial expertise that benefits the
company’s shareholders (Booth and Deli, 1999). However, because the CBD is
employed by the commercial bank, the CBD’s interests are aligned with (potential)
creditors of the company. The CBD’s interests could therefore diverge from the company
shareholders’interests.
Prior literature has found that CBDs provide industry-specific knowledge, enhance
monitoring and provide debt market expertise to management (Diamond, 1984; Boyd
and Prescott, 1986; Booth and Deli, 1999; Kroszner and Strahan, 2001; Byrd and
Mizruchi, 2005). In addition, researchers have investigated areas of corporate financial
decisions in which the financial expertise of the CBDs and their associated conflicts of
interest are salient, such as mergers and acquisitions (M&As; Hilscher and Sisli-
Ciamarra, 2013), capital structure (Sisli-Ciamarra, 2012; Kuo et al., 2010), investment
decisions (G€
uner, et al., 2008; Dittman et al., 2010; Mitchell and Walker, 2008; Slomka-
Golebiowska, 2012), accounting conservatism (Erkens et al., 2014), and innovative
activities (Ghosh, 2016). In this paper, we look at CEO incentives.
CEO incentives have been an important area in corporate finance research in which
optimal compensation is understood as a linear function of the aggregate information
about the firm’s output (Holmstrom and Milgrom, 1987; Jensen and Murphy, 1990;
Aggarwal and Samwick, 1999a, 1999b; Murphy, 1999, 2011; Core and Guay, 2002;
Coles et al., 2006; Frydman and Jenter, 2010). Financial experts could process the
company’sfinancial and operating performance information more effectively. Hence,
© 2016 John Wiley & Sons, Ltd.
Bankers on the Board and CEO Incentives 293
they could tie the CEO’s incentives to the company’sfinancial performance more
effectively (Holmstrom and Kaplan, 2003) than non-CBDs could. Therefore, our first
research question is as follows: Do CBDs make CEO’s incentives more sensitive to firm
performance? We hypothesise that the CEO’s pay–performance sensitivity (PPS) is
higher when CBDs are present (Jensen and Murphy, 1990) and we call this the financial
expertise hypothesis.
At the same time, since the CBDs come from (potential) lending banks, their decisions
could be subject to conflicts of interest between shareholders and debtholders (Jensen
and Meckling, 1976). While CBDs have a fiduciary duty to shareholders, that is, people
who prefer risk-increasing decisions, the CBDs’incentives arising from their employing
banks would induce them to prefer risk-reducing decisions (Black and Scholes, 1973;
Jensen and Meckling, 1976; Myers, 1977; Kim and Sorensen, 1986). Therefore, our
second research question is the following: Do CBDs influence CEO incentives to be
more aligned with creditors’interests? We hypothesize that CBDs could influence the
CEO’s compensation contract to decrease firm risk. We call this the conflicts of interest
hypothesis.
The structure of CEO compensation has various components that can have different
degrees of incentive alignment with shareholders and debtholders. Some components,
such as stock options and restricted stock ownership, would incentivise the CEO to make
decisions from the shareholder’s perspective. On the other hand, pension or deferred
compensation, that is, debt-like compensation, could incentivize the CEO to make
decisions from the debtholder’s perspective (Sundaram and Yermack, 2007). In addition,
the board of directors could make the CEO compensation more or less sensitive to the
firm risk to influence the risk taking of the CEO (Core and Guay, 2002; Coles et al.,
2006). Therefore, under the conflicts of interest hypothesis, debt-like CEO compensa-
tion, such as pension and deferred compensation, would increase with CBD presence,
while the sensitivity of CEO compensation to risk, measured by VEGA, would decrease
in the presence of CBDs. In addition, under the financial expertise hypothesis, CEO
compensation sensitivity to performance, measured by PPS, would show a positive
relationship with CBD presence and debt-like compensation would increase in
accordance with firm performance.
Based on the intersection of Exec uComp and BoardEx data from 1999 to 2007, we
find supporting evidence for th e conflicts of interest hypothesis for CBDs, regardless
of whether the CBD is affiliated with a lending bank or not. Following G€
uner et al.
(2008), we define an affiliated banker director (ABD) as one who works for the bank
that currently has or previo usly (up to 5 years prior) had some type of loan exposure
with the monitored company ac cording to the DealScan dat abase. When ABDs are
present, we find that the sensitivit y of CEO compensation to firm risk (VEGA)is
significantly smaller. Fur ther investigation shows th at debt-like compensation is more
sensitive to performanc e and less sensitive to risk i n the presence of ABDs. We find
that the negative correl ation between VEGA and ABD pre sence is stronger if the ABD
is the chair of the compensa tion committee. Our finding is robust after controlling for
the potential selection bia s of having CBDs. We also find that debt-like compensation
is significantly higher when CB Ds are present, which is the first time this association
is reported in the literatu re. We also find that the industry -relative VEGA of CEO
compensation significantl y decreases after the appoint ment of CBDs. Lastly, we find
that the industry-relati ve leverage ratio significa ntly increases after the dep arture
of CBDs.
© 2016 John Wiley & Sons, Ltd.
294 Min Jung Kang and Andy (Y. Han) Kim
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