Effect of Corporate Governance on CEO Pay - Risk Taking Association: Empirical Evidence from Australian Financial Institutions

This study explores the impact of board structures on risk taking-CEO pay association in Australian financial institutions. Using a panel data of 45 listed Australian financial institutions for the period 2004-2015, we examine the empirical relationship between firms expected default probability and CEO pay. Our results show that deposit taking institutions with a greater number of nonexecutive directors on the board generally have an expected default probability (EDP) that is more sensitive to CEO short-term employee benefits. However, a lower response of EDP to changes in CEO short-term employee benefits in non-deposit taking institutions is observed. To a large extent, this phenomenon is explained by the existence of moral hazard problem in banking industry. As depositors are insured against losses, nonexecutive directors may fail to monitor executives taking on risky investments that generate short-term gains in order to boost their cash bonus and other short-term risk remuneration. Our results suggest that boards associated with more nonexecutive directors' increase (reduce) the responsiveness of expected default probability to changes in CEO short-term employee benefits (long-term variable remuneration pay). We observe that Australian financial institutions with large boards are linked to EDP which is sensitive to both CEO short-term and long-term remuneration incentives. Institutions with larger boards motivate their CEOs to invest in high risk financial assets, consequently escalating the level of CEO risk-taking. Finally, independence of the board members plays a critical role in reducing the level of CEO risk-taking only if CEO remuneration is largely made of long-term incentives remuneration such as options and share restricted payments. In line with other studies from US, boards should use long-term incentives in CEO remuneration to reduce agency costs and increase firm value.