Executive Compensation and Risk Taking: The Impact of Systemic Crises

Abstract

It is widely accepted that managerial compensation packages contributed to the excessive risk-taking practices that led to the onset of the Great Recession (2007–2009). We argue that the relationship between managerial compensation and risk taking is procyclical. A given level of performance incentives may result in significantly lower firm risk when economy is in a systemic crisis because managers face an increased employment risk during economic downturns. Students of finance who will become policy makers or who will sit on compensation committees would benefit from realizing that in order to implement a given level of firm risk, managerial compensation packages may need to be adjusted according to the state of the economy.