CEO Compensation Structure and Firm Risk Taking - A case study of the CEO compensation practices in the Swedish financial industry

Abstract: Background: The CEO compensation structure is seen as one of the underlying causes of the recent financial crisis, and is a phenomenon that has been heavily debated lately both within the financial industry, by policymakers all over the world, and in business media. A very typical view nowadays appears to be that at least a partial cause underlying the recent financial crisis is the way the executive compensation systems, especially in the financial industry, have been structured. The popular opinion has proven itself to be that executive compensation systems have relied too heavily on variable compensation features (equity based compensation and annual bonuses), which in turn have induced CEOs to expose the companies they are managing to excessive risks. Policymakers all over the world have really taken this critique seriously and for instance the Swedish financial authority (Finansinspektionen) has been asked to present a proposal for new regulation regarding how the executive compensation systems in the Swedish financial industry should be structured in the future. Problem Formulation: Are the CEO compensation systems in the Swedish financial sector structured to promote risk taking? Purpose: The main purpose of this thesis is to investigate the relationship between how CEO compensation systems, in Swedish financial and industrial firms, have been structured during the last decade and the actual risk taking in those industries. Limitations: The empirical analysis in this thesis is limited to include financial and industrial firms listed on the Swedish stock exchange. Furthermore, our study is limited to only consider publicly available information about the firms in our investigation sample. Methodology: Brief presentation of the most important existing economic theory related to the topic of executive compensation. Collection of the data needed for our empirical analysis from the annual reports of each firm included in our investigation sample, for the relevant time period. The empirical analysis is performed in two separate steps; first measures of firm risk taking are generated through a one-factor index model and second a regression model for investigating the relation between CEO compensation structure and firm risk taking is defined. The obtained results are then analyzed and related to the findings of comparable earlier studies. Results: First of all we can conclude there are structural differences in the CEO compensation structure between the investigated business sectors. Overall, our obtained results regarding the relationship between the relative proportion of total CEO compensation that is variable and firm risk taking suggest no significant influence. For the sample of financial firms we however find evidence in favor of the contracting hypothesis, when firm risk taking is approximated by total stock market risk. In general, our main conclusion is that there are no observable relationship between market-based measures of risk and the structure of CEO compensation, especially in the industrial sector. On the other hand our results suggest that the stock market risk measures appear to be highly dependent of the overall state of the Swedish economy, since several of the year dummies in or regression model are highly significant for explaining variation in the risk measures that serve as approximations for firm risk taking throughout this thesis.