Managerial Risk-Taking Incentives and Bank Earnings Management: Evidence from FAS 123R

We study the effect of CEOs' risk-taking incentives (vega), derived from their stock options, on earnings management (EMGT) by banks. Prior research finds an inconsistent relationship between vega and EMGT in non-financial firms. In the banking industry, the effect of vega on EMGT is further complicated by the strict regulatory environment. To establish causality, we exploit the exogenous reduction in vega resulting from Financial Accounting Standard (FAS) 123R in 2005 that mandates a fair-value-based method to expense stock options and increases costs of granting option compensation. Using the difference-in-differences approach, we find that banks with a larger drop in CEO vega due to FAS 123R significantly reduce EMGT. The findings suggest that CEO vega has a positive and causal effect on bank EMGT. Our results are robust enough to employ in different research designs and specifications. Furthermore, we find that the negative effect of FAS 123R on EMGT is weaker in banks subject to a higher possibility of regulatory intervention.