Bankers on the Board and CEO Incentives

AuthorAndy (Y. Han) Kim,Min Jung Kang
Date01 March 2017
Publication Date01 March 2017
Bankers on the Board and
CEO Incentives
Min Jung Kang
University of MichiganFlint, 2138 Riverfront Center, 303 E. Kearsley Street, Flint, MI 48502, USA
Andy (Y. Han) Kim
SungKyunKwan University (SKKU), Room 524, Business School Building, SungKyunKwan University,
Jongno-gu, Seoul, Korea, 110-746
The Sarbanes-Oxley Act demanded the presence of more nancial experts on
corporate boards to improve governance. Directors from lending banks require
particular attention because of the conicts of interest between shareholders and
debtholders despite their nancial expertise. In this paper, we examine whether
commercial banker directors work in the best interests of shareholders in
providing incentives to the CEO. We nd that the CEOs compensation VEGA is
lower if an afliated banker director is on the board. Further, we nd that
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 SKKUPeking 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 Moodys 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, 292324
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
ofcers (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 directorspreferences could
diverge from those of the shareholders, depending on the directors background.
Among the many different backgrounds of boards of directors, commercial banker
directors (CBDs) deserve special attention due to their nancial expertise and potential
conicts 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 dened as an outside director in a
non-nancial rm who is also an executive of a commercial bank. The bank may or may
not have loan exposure to the rm. Because one needs to have adequate expert
knowledge and an extensive professional network in nancial markets to be promoted as
a bank executive, a CBD is assumed to have nancial expertise that benets the
companys shareholders (Booth and Deli, 1999). However, because the CBD is
employed by the commercial bank, the CBDs interests are aligned with (potential)
creditors of the company. The CBDs interests could therefore diverge from the company
Prior literature has found that CBDs provide industry-specic 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 nancial
decisions in which the nancial expertise of the CBDs and their associated conicts 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 nance research in which
optimal compensation is understood as a linear function of the aggregate information
about the rms 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
companysnancial and operating performance information more effectively. Hence,
© 2016 John Wiley & Sons, Ltd.
Bankers on the Board and CEO Incentives 293
they could tie the CEOs incentives to the companysnancial performance more
effectively (Holmstrom and Kaplan, 2003) than non-CBDs could. Therefore, our rst
research question is as follows: Do CBDs make CEOs incentives more sensitive to rm
performance? We hypothesise that the CEOs payperformance sensitivity (PPS) is
higher when CBDs are present (Jensen and Murphy, 1990) and we call this the nancial
expertise hypothesis.
At the same time, since the CBDs come from (potential) lending banks, their decisions
could be subject to conicts of interest between shareholders and debtholders (Jensen
and Meckling, 1976). While CBDs have a duciary duty to shareholders, that is, people
who prefer risk-increasing decisions, the CBDsincentives 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 inuence CEO incentives to be
more aligned with creditorsinterests? We hypothesize that CBDs could inuence the
CEOs compensation contract to decrease rm risk. We call this the conicts of interest
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 shareholders perspective. On the other hand, pension or deferred
compensation, that is, debt-like compensation, could incentivize the CEO to make
decisions from the debtholders perspective (Sundaram and Yermack, 2007). In addition,
the board of directors could make the CEO compensation more or less sensitive to the
rm risk to inuence the risk taking of the CEO (Core and Guay, 2002; Coles et al.,
2006). Therefore, under the conicts 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 nancial 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 rm performance.
Based on the intersection of Exec uComp and BoardEx data from 1999 to 2007, we
nd supporting evidence for th e conicts of interest hypothesis for CBDs, regardless
of whether the CBD is afliated with a lending bank or not. Following G
uner et al.
(2008), we dene an afliated 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 nd that the sensitivit y of CEO compensation to rm risk (VEGA)is
signicantly 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 nd
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 nding is robust after controlling for
the potential selection bia s of having CBDs. We also nd that debt-like compensation
is signicantly higher when CB Ds are present, which is the rst time this association
is reported in the literatu re. We also nd that the industry -relative VEGA of CEO
compensation signicantl y decreases after the appoint ment of CBDs. Lastly, we nd
that the industry-relati ve leverage ratio signica 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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