Executive stock options and systemic risk

Employing a novel control function regression method that accounts for the endogenous matching of banks and executives, we find that equity portfolio vega, the sensitivity of ex-ecutives' equity portfolio value to their firms' stock return volatility, leads to systemic risk that manifests during subsequent economic contractions but not expansions. We further find that vega encourages systemically risky policies, including maintaining lower com-mon equity Tier 1 capital ratios, relying on more run-prone debt financing, and making more procyclical investments. Collectively, our evidence suggests that executives' incentive -compensation contracts promote systemic risk-taking through banks' lending, investing, and financing practices.(c) 2021 Elsevier B.V. All rights reserved.