1. Inside Debt and Bank Performance During the Financial Crisis DNB 2012 Sjoerd van Bekkum

2. Initiatives to reduce excessive risk taking incentives after the crisis  Compensation Fairness Act 2009  Shareholders should approve pay  Shareholders appoint compensation directors  Dodd-Frank Wall-Street Reform 2010  Shareholders should vote on pay  Shareholders can design their own pay proposals  G20’s FSB Sound Compensation Practices 2009  “Engage shareholders with compensation”  50% of variable pay should be awarded in shares or share-linked instruments  All shareholder-based! 2

3. Why this focus on aligning shareholder interests within in banks to limit risk?  Academic evidence on shareholder alignment and bank risk-taking is mixed at best (e.g., Fahlenbrach & Stulz ‘11)  Equity-based pay is convex, and increases risk….  Holds for options and restricted stock  Equity-based pay encourages risk-shifting in banks: 1.Banks are highly levered (E/A<0.10)  losses are easily shared with debtholders (Bebchuk & Spamann 2010) 2.Bank losses are also shared with taxpayers (LLOR, deposit insurance, implicit government guarantees)  if executive’s actions are unobserved, she will shift risk to taxpayers and other debtholders (Bolton et al. 2006) 3

4. This paper focuses on aligning debtholder incentives using inside debt  Inside debt consists of debt from firm to manager: -pensions -retirement plans -Other deferred compensation  So if bank goes broke, the managers waits in line with other creditors (Sundaram & Yermack, 2007)  Hence, ID aligns interests between managers and debtholders (and un-aligns them with equityholders)  Indeed, inside debt leads to more conservative decision making for industrials (Cassell et al., 2011) 4

5. Inside debt encourages conservatism which pays off during bad times: 1.Shareholder implications: More inside debt  better returns during crisis 2.Debtholder implications: More inside debt  less downside risk during crisis 3.Investment policy: More inside debt  better quality asset portfolio 4.Financing policy: More inside debt  less “outside” debt 5

6. Main Result: Returns over the crisis 6

7. Data  Inside debt is disclosed mandatorily from 2006  2006 compensation  Crisis runs from July 2007 to March 2009  July 2007 – March 2009 risk/return measures  All lending institutions from largest 3000 firms  Fiscal year ending in December 2006  “substantial” part in lending business  executives with nonzero inside debt (is relaxed later)  319 banks 7

8. Measuring enterprise-wide bank risk  Enterprise-wide bank risk: shareholders + debtholders  No bonds/CDS data for most banks  Risk measures based on equity returns distribution 8 VaR ES CoVaR Volatility (T/S/I)

9. Measuring realized enterprise-wide bank risk  Enterprise-wide bank risk: shareholders + debtholders  No bonds/CDS data for most banks  Risk measures based on equity returns distribution  VaR  Expected shortfall  CoVaR  Total / Systematic / Idiosyncratic volatility  Prob(equity loss > 80%)  Risk-taking:  Asset quality: % nonperforming assets ‘08  Jan07-Jun07 repo growth 9

10. Measuring inside debt  Main idea (Jensen & Mecklin 1976): Optimally, manager’s D/E = firm’s D/E.  Measured in levels (Edmans & Liu 2011) and 1 st differences (Wei & Yermack 2011) 10

11. Empirical model where bank risk R is captured by, VaR, ES, CoVaR, and Prob(equity loss > 80%) 11

12. Results: BHRs 12

13. Results: Volatility 13

14. Results: Enterprise- Wide risk 14

15. Results: Risk-taking 15

16. Endogeneity concerns These findings are also consistent with:  Inside debt being only awarded when expected future risk is low! Risk is measured around unanticipated shock Impact of 2006 debt on 2007-2008 realized risks Accumulated pensions are stock, not flow  Inside debt is only awarded by banks operating in a stable environment 2006 volatility does not explain realized risks inside debt discourages pre-crisis repo growth  Re-estimation using IV: 16

17. Endogeneity concerns Re-estimation using IV:  Executive age (Fahlenbrach & Stulz; Sundaram & Yermack 2007)  Size (exluding TBTF)  Tax status (Sundaram & Yermack 2007)  Maximum state tax rate (Anantharaman et al. 2010)  Newly hired executive (Sundaram & Yermack 2007)  Industry median inside debt (Murphy 1999)  previous controls 17

18. Results: IV estimates 18

19. More alternative explanations: I also do the following robustness checks:  10% of all banks disappear from sample  Adjust BHR for return after merger/delisting  Include executives without any inside debt  Create a 0/1 variable for whether sb has inside debt  Re-estimate model on expanded sample  Presented estimates are at the executive level  Results also hold at the CEO/CFO/bank level  Too-big-to-fail institutions might pay more inside debt AND are less risky  Results also hold without TBTF banks 19

20. Results: Robustness 20

21. Conclusion  Inside debt limits bank risk: less negative returns lower volatility and tail risk discouragement of risk-taking  Power shift in governance from shareholders to debtholders limits risk Inside debt  less risk  better performance during crises  Trade-off between upside potential and downside risk is beyond the scope of this paper  But given that risk should be limited, inside debt might be a way to do it. 21

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