CEO inside debt and hedging decisions: Lessons from the US banking industry

Theoretical literature (Jensen and Meckling, 1976; Edmans and Liu, 2011) argues that inside debt - pension benefits and deferred compensation - has debt-like payoffs, and can therefore curb executives' excessive risk-taking incentives created by equity holdings. We test this theory in the banking sector by investigating whether CEOs with larger inside debt holdings compared to their equity-based compensation hedge more their banks' interest rate risk. Our results show that CEO inside debt holdings have a positive effect on the extent to which a bank uses interest rate derivatives for hedging purposes, implying that debt-like compensation mitigates bank executives' risk-taking incentives. Our results have important implications for financial regulation attempting to prevent financial crises due, at least partially, to perverse incentives provided to bank executives through compensation. (C) 2012 Elsevier B. V. All rights reserved.