Executive Compensation and Firm Risk-taking: A study of the Compensation Practices in the UK Financial Industry

Abstract: The structure of executive compensation is seen as one of the underlying causes of the financial crisis of 2008. A common opinion is that firms have relied too heavily on equity-based compensation and that this have promoted excessive risk-taking. This paper investigates the relationship between executive compensation and firm risk-taking in the UK financial industry between 2004 and 2010. The aim is to extend the literature by highlighting one of the largest economies in Europe and to study whether or not the growing critique of the remuneration practices in the UK is justified. A balanced panel of 25 firms was investigated and two compensation variables and three market-based risk measure were used to determine whether or not executive compensation can explain firm risk-taking. I also controlled for several firm-specific factors such as size and leverage. The empirical analysis was carried out in two separate steps. First, I used a simple factor model to estimate the market-based risk measures for each firm. I then ran a fixed effects regression with each of the three risk measures as the dependent variables against each of the compensation variables. The results do not indicate any strong relationships between executive compensation and firm risk-taking. Consequently, I find little or no justifying evidence for the growing critique of the remuneration practices in the UK.dd