Yesterday’s Heroes Compensation and Risk.pdf

THE JOURNAL OF FINANCE • VOL. LXX, NO. 2 • APRIL 2015 Yesterday’s Heroes: Compensation and Risk at Financial Firms ∗ ´ ING-HAW CHENG, HARRISON HONG, and JOSE A. SCHEINKMAN ABSTRACT Many believe that compensation, misaligned from shareholders’ value due to man- agerial entrenchment, caused financial firms to take risks before the financial crisis of 2008. We argue that, even in a classical principal-agent setting without entrenchment and with exogenous firm risk, riskier firms may offer higher total pay as compensation for the extra risk in equity stakes borne by risk-averse managers. Using long lags of stock price risk to capture exogenous firm risk, we confirm our conjecture and show that riskier firms are also more productive and more likely to be held by institutional investors, who are most able to influence compensation. MANY BLAME WALL STREET COMPENSATION for the most significant economic crisis since the Great Depression. For instance, in his testimony to Congress on the Treasury budget on June 9, 2009, Treasury Secretary Geithner argues, “I think, although many things caused this crisis, what happened to compensation and the incentives that created risk taking did contribute in some institutions to the kind of vulnerability we saw in this financial crisis” (emphasis added)1 . As a result, U.S. policy makers have promoted reforms to tie pay to long-term performance and increase the say of shareholders in approving compensation and electing directors on compensation committees. The view that incentive misalignment contributed to the crisis