Given banks’ importance to global economic stability, how they manage liquidity – their capacity to transform short-term liabilities into long-term assets – plays a pivotal role in supporting growth while maintaining financial resilience. It also entails considerable risk. Creating more liquidity increases banks’ exposure to risk, particularly when market conditions shift, posing potential challenges for financial stability. Risk management is, therefore, crucial for bank performance and economic health.

Important yet underexplored elements in encouraging prudent risk management are CEO pay and how the gap between it and non-CEO pay affects bank liquidity creation. That gap plays a substantial role in shaping executive incentives. High pay gaps can motivate executives through “tournament-like” incentives, driving non-CEO executives to engage in ambitious, high-stakes strategies such as liquidity creation to compete for the CEO position. Alternatively, larger pay gaps may signal the CEO’s influence, potentially leading to more conservative strategies to safeguard their position, a scenario rooted in CEO power theory. Examining these dynamics is particularly timely, given the increasing regulatory focus on income disparity and responsible compensation within the financial industry. By investigating this relationship in a new paper, we address pressing questions around compensation structure, economic stability, and regulatory interventions.

CEO Pay Gaps, Risk-Taking, and the Broader Economic Impact

At the heart of our analysis is the dual impact of pay disparities on risk-taking behavior and economic outcomes. Banks’ liquidity creation fuels economic growth by financing investments that may not otherwise receive funding. But regulations imposed after the financial crisis, such as those embedded in Basel III and executive pay caps under programs like TARP, have heightened concerns about the potential downsides of unbridled risk-taking by bank executives. Policymakers face a challenge: creating frameworks that discourage excessive risk without stifling the productive risk-taking essential for liquidity creation and economic expansion. Thus, our paper’s focus on the role of CEO pay gaps is motivated by the need to understand how these disparities influence executive behavior in ways that affect bank performance, market stability, and economic vitality.

CEO Pay Gaps Drive Liquidity Creation

The paper reveals that banks with relatively large CEO pay gaps engage in higher levels of liquidity creation, especially when they have strong governance and capital reserves. This effect is magnified under TARP restrictions, which widened pay gaps and inadvertently enhanced tournament incentives. The evidence suggests that tournament effects – where non-CEO executives are motivated to compete for the CEO role – outweigh risk aversion effects associated with CEO power theory. Our findings also show that this relationship is strongest in well-capitalized, large banks with robust governance, underscoring the importance of organizational context in interpreting pay gap effects on bank behavior.

Designing Effective Compensation and Liquidity Regulations

1. Rethinking Compensation Limits

Compensation limits, like those under TARP, may dampen income inequality but can also heighten tournament incentives that drive liquidity creation. While intended to limit risk, these caps may inadvertently support risky, liquidity-enhancing activities. Regulators should consider flexible compensation frameworks that allow liquidity creation while managing systemic risk. For example, structuring performance-based incentives to reward sustainable growth can align executives’ motivations with long-term stability.

2. Tailoring Liquidity Regulations to Bank Characteristics

The paper’s findings suggest that well-capitalized banks with strong governance benefit more from tournament incentives and are better able to absorb liquidity-related risks. Policymakers could tailor liquidity requirements to bank size, capital levels, and governance strength, allowing banks with greater risk-absorbing capacities to maintain liquidity creation activities that support economic growth without increasing systemic risk.

3. Incorporating Competition and Shareholder Rights

External factors like competition and shareholder litigation also moderate the impact of CEO pay gaps on liquidity creation. Increased competition fosters market discipline that can reduce the reliance on pay gaps to drive risk-taking. Similarly, stronger shareholder rights encourage oversight of executive decisions, particularly regarding liquidity creation. Policymakers should consider enhancing market competition and shareholder protections to complement internal pay structures, fostering a balanced approach to risk and performance.

4. Insights for Future Crisis-Response Programs

The TARP experience illustrates how crisis-driven compensation restrictions can shape executive behavior in unintended ways. In future bailouts, compensation frameworks could be designed to promote stability without encouraging excessive risk-taking. Tying bonuses to long-term performance metrics rather than short-term liquidity boosts, for example, may help avoid high-yield, illiquid investments that can undermine stability during crises.

5. Implications for International Regulatory Standards

International frameworks, such as those created by the European Banking Authority, increasingly limit executive bonuses. Our findings underscore the importance of flexibility in compensation structures, especially in systemically important banks where liquidity creation is critical. Regulators might consider policies that allow for variable pay structures, ensuring that compensation supports liquidity creation without fostering excessive risk.

Balancing Compensation and Stability in Banking

Our paper reveals that CEO pay gaps have a significant impact on bank liquidity creation, influencing risk-taking behaviors with broader implications for financial stability. As policymakers refine compensation guidelines, they should consider the potential of pay structures to support productive risk-taking while mitigating excessive risks. A balanced regulatory approach can foster a resilient financial sector, supporting growth while maintaining the safeguards necessary to prevent systemic vulnerabilities. This nuanced perspective on executive incentives can guide more adaptable, effective compensation policies in banking.

This post comes to us from Shams Pathan and Mamiza Haq at Newcastle University’s Newcastle University Business School, Chen Zheng at Curtin University, and Adrian (Wai Kong) Cheung at the City University of Macao. It is based on their recent paper, “Pay gap matters: Evidence from bank liquidity creation,” available here.