The current issue and full text archive of this journal is available at

www.emeraldinsight.com/0307-4358.htm

MF
34,5
Bank mergers, equity risk
incentives, and CEO stock options
Melissa A. Williams and Timothy B. Michael
University of Houston-Clear Lake, Houston, Texas, USA, and
316 Ramesh P. Rao
William S. Spears School of Business, Oklahoma State University, Stillwater,
Oklahoma, USA
Abstract
Purpose – The purpose of this paper is to examine the risk-incentive effect of CEO stock options in
the banking industry.
Design/methodology/approach – For a sample of industrial mergers, Williams and Rao find that
the risk-incentive effect of CEO stock options is associated with higher post-merger risk. This result
indicates that stock options may be effective in mitigating the agency problem of Jensen and Meckling
wherein managers take too little risk on behalf of shareholders. The authors extend the method of
Williams and Rao to the banking industry. In particular, they are interested in determining whether the
same relationship holds for these highly regulated and leveraged firms.
Findings – Using a sample of 131 bank mergers that took place between 1993 and 2002, the authors
determine that the risk-incentive effect of CEO stock options is positively related to the post-merger level
of equity risk. The results of this study also show that the interaction of size and the risk-incentive effect
is negatively related to volatility following the merger, which agrees with the original study.
Originality/value – This paper extends the literature by examining an industry that is largely ignored
because of its highly regulated nature.
Keywords Compensation, Stock options, Banking, Acquisitions and mergers, Equity capital, Risk
analysis
Paper type Research paper

Managerial Finance
Vol. 34 No. 5, 2008
pp. 316-327
# Emerald Group Publishing Limited
0307-4358
DOI 10.1108/03074350810866199
1. Introduction
Agency problems that arise in a publicly held corporation have been a focus of
academic research for some time. One such problem has to do with optimal risk-taking
behavior. It is widely accepted (e.g. Jensen and Meckling, 1976) that managerial risk
aversion combined with an excessive concentration of managerial wealth (both human
and financial) in a single firm predisposes managers to reduce risk to a level that is less
than optimal from the outsider shareholders’ perspective. From an agency theory
perspective it has been argued (e.g. Jensen and Meckling, 1976; Haugen and Senbet,
1981; Hall, 1998; Murphy, 1998) that because option values are a positive function of the
underlying asset variance, incorporating stock options into managerial compensation
will have the desired effect of motivating managers to invest in higher risk projects
than would be possible otherwise.
Research also suggests that the corporate governance of banking firms should
differ from that of industrial firms (Adams and Mehran, 2003; Macey and O’Hara,
2003). In particular, commercial banks face different risk, capital structure, and
regulatory environments than firms that have been traditionally studied for
governance effects on managerial risk aversion. This study provides insight into the
effectiveness of stock options in mitigating managers’ risk aversion with an emphasis
on bank merger events.
Our approach examines whether stock option grants influence subsequent
managerial choices of corporate assets with regard to their impact on equity variance.
Following Williams and Rao (2006) and Agrawal and Mandelker (1987), we focus on Bank mergers
mergers and acquisitions because these events represent significant changes in the
asset structure of the bank.
and CEO stock
For a sample of bank mergers between 1993 and 2002, we find that the ratio of post- options
merger variance to pre-merger variance is positively related to the risk-incentive effect
of CEO stock option holdings. In addition, we find that the size of the firm is positively
related to the post-merger volatility ratio, and an interaction term between option
compensation sensitivity to risk and size is negatively related to the volatility. 317
Combined, these results suggest that firm risk increases as banks get larger via
mergers however it appears that the impact of the risk-incentive effect of options on
merger volatility is comparatively lower for larger banks. We include two traditional
measures of bank risk (capital and leverage) and find them to be important in
determining the relationship between compensation and post-merger volatility as well.

2. Literature review
Prior research regarding stock option compensation is fairly extensive, as is the
literature examining the characteristics of pay-performance sensitivity. Our focus here
is narrow – we concentrate on the role of stock options in motivating risk-averse
managers to engage in risky projects preferred by shareholders. In particular, we ask
whether the risk outcomes of mergers between banking firms may be differentially
impacted by option-based incentives.

2.1 Equity risk and compensation

The agency theory literature suggests that an executive’s holdings of stock options
could play a significant role in aligning managerial incentives with shareholder
interests. The literature widely recognizes the potentially useful role of stock options in
motivating risk-averse managers to engage in risky projects preferred by shareholders.
Studies that shed light on this aspect of managerial stock option holdings include
Hirshleifer and Suh (1992), Haugen and Senbet (1981), Smith and Stulz (1985), Hall
(1998), and Carpenter (2000).
Hirshleifer and Suh (1992) argue that option plans help mitigate the effects of
excessive risk aversion by giving managers incentives to adopt rather than avoid risky
projects. Using typical firm level data, Hall (1998) shows that the value of a standard
employee stock option plan varies dramatically with the volatility of the stock. Hall
finds that the average volatility of the publicly traded stock is just over 0.3 and raising
it to 0.6 will cause the option value to increase from 36 per cent of the share price to 52
per cent of the share price. Hall concludes ‘‘[T]o the extent that CEOs can significantly
raise the volatility of their stock prices without offsetting mean returns, they can raise
the value of the stock options substantially’’. Thus stock options have the potential to
serve as a powerful mechanism to alter managers’ risk incentives. It is important to
note that the mere presence of stock options in the compensation package does not
necessarily ensure managerial willingness to take on more risky projects. As noted by
Hall, Guay (1999) and others, CEO propensity for risk taking is affected by the
convexity of the option pay-off function and the CEO’s degree of risk aversion, the latter
is in turn a function of such things as the CEO’s wealth, tenure, age, and other
considerations.
Haugen and Senbet (1981) show that while call options create an incentive to shift to
high-risk investment opportunities, put options (e.g. convertible bonds) retained by
outside capital contributors ‘‘creates a countervailing’’ force to excessive risk-shifting
MF incentive. Smith and Stulz (1985) present theoretical analysis of what determines
34,5 corporate hedging behavior. They demonstrate that by making compensation a more
convex function of firm value shareholders can discourage ‘‘managers from devoting
excessive resources to hedging’’. Their study implies that including stock option
elements in executive compensation packages can mitigate the tendency for risk-
averse managers to hedge. Carpenter (2000) explores several classes of utility functions
318 and how they affect managers’ dynamic adjustment of asset volatility when the options
they hold cannot be hedged. Her findings imply that granting more options do not
necessarily lead to managers’ seeking greater risk. For example, Carpenter shows that
if a manager has constant relative risk aversion, granting more options increases the
volatility of his personal portfolio causing the manager to reduce the volatility of the
underlying asset.
The aforementioned theoretical studies provide strong justification for the role of
managerial stock option compensation in influencing managerial risk-taking behavior.
However, direct empirical evidence on the role of managerial stock option
compensation on subsequent investment decisions and volatility is very limited and
mixed.
DeFusco et al. (1990) find that stock price volatility increases after the approval of
stock option plans. Tufano (1996) reports evidence consistent with Smith and Stulz’s
(1985) prediction by documenting a negative relation between the extent of corporate
hedging and options held by senior managers of gold mining firms. Agrawal and
Mandelker (1987) look at the relationship between a manager’s security holdings of his
or her firm, which include common stock and options, and the firm’s financing as well
as investment decisions. They find evidence of a positive relationship between the
security holdings of the executives and changes in firm variance surrounding these
asset changes. They also find evidence of a positive relationship between the security
holdings of the executives and financial leverage changes surrounding acquisitions
and divestitures. Since Agrawal and Mandelker do not distinguish between managerial
stock and option holdings, it is unclear if their results are driven by stock or option
holdings of managers. Williams and Rao (2006) document that the ratio of post- to pre-
merger stock return variance for a sample of industrial mergers between 1994 and 1996
is positively related to the risk-incentive effect of CEO stock option compensation but
this relationship is conditioned on firm size, with firm size having a moderating effect
on the risk-incentive effect of stock options. They measure the stock option risk
incentive by taking the partial of the Black-Scholes (B-S) option value to the underlying
stock return volatility, a measure suggested by Core and Guay (2002). Williams and
Rao also find that for a broad time-series cross-sectional sample of firms from 1994 to
1996 there is a strong positive relationship between CEO risk incentive embedded in
the stock options and subsequent equity return volatility. As in the case of the merger
sample, this relationship is stronger for smaller firms.
Rajgopal and Shevlin (2002) focus on stock option effects on risk-taking behavior in
the oil and gas production industry. They posit that if employee stock options are
designed to motivate managers to make high-risk investments then we should observe
a positive association between employee stock option risk incentives and the variance
of cash flows from exploration activity. They use the Core and Guay proposed measure
to capture the risk-incentive effect of managerial stock option holdings. Rajgopal and
Shevlin conclude ‘‘exploration risk is strongly associated with employee stock option
risk incentives in the predicted direction’’.
 Guay (1999) studies the magnitude and determinants of the CEO stock option Bank mergers
convexity. Using the Core and Guay method of determining the sensitivity of CEO
option portfolio to equity volatility, Guay finds that convexity of CEO stock options is
and CEO stock
positively related to growth options. In a separate regression, Guay finds that the options
equity risk is positively impacted by the sensitivity of CEO stock options to volatility
even after controlling for leverage, size, and other variables. Guay’s findings are based
on compensation data for a single year, 1993, using a sample of 278 of the largest 1,000
firms on the Compustat tapes in 1988.
319

2.2 Corporate governance in banking

Although there is a rich existing literature on the pay-performance sensitivity of
compensation within commercial banks (see John and Qian, 2003), there has been little
effort to explain the relation between the risk-incentive effect of CEO option
compensation and the equity risk outcomes of bank mergers. Bliss and Rosen (2001)
examine how changes in a bank’s operating environment can have an impact on the
structure of CEO compensation, and their results imply that equity-based
compensation may be able to provide incentives for bank CEOs to engage in value-
enhancing activities. They find, however, that equity-based compensation is higher at
banks that merge less often. They also report that performance in the year prior to a
merger is highly correlated with the probability of the merger decision, suggesting that
banks are more likely to initiate mergers when managers feel that the banks shares are
overpriced, consistent with Myers and Majluf (1984).
In many ways, the role of corporate governance in the banking industry is
considered to be distinct from that of corporate governance in a general context (see
Macey and O’Hara, 2003). In particular, financial services firms are highly regulated at
both the state and national levels. Some authors (for example, John et al., 2000) have
suggested that management controls via incentives may serve as a substitute for
certain types of regulation.
Another difference between banks and other firms is in the use of financial leverage.
Typically bankers finance less than 10 per cent of total assets with equity[1]. Citing the
moral hazards traditionally associated with holding insured consumer deposits,
regulators have required at least this level of equity financing and have designed a
system of risk-based capital requirements to encourage firms to use more equity if they
hold riskier assets[2].
In addition to these considerations, the agency problems inherent in the typical firm
may be only one small component of the incentive problems faced by bank
shareholders. Although managers may be predisposed to reduce risk levels in certain
contexts, in the manner described by Jensen and Meckling (1976) and others, there may
be additional incentives for ex post risk shifting in the banking firm. Bank assets are
much more sensitive to changes in interest rates and other market conditions than the
assets of other firms, and this sensitivity combined with the use of leverage and the
availability of deposit insurance may create additional moral hazards for bank
managers with respect to regulators and depositors as well as creditors. John and John
(1993) suggest that a firm’s risk may have an attenuating effect on incentives to shift
risk toward debtholders. In the case of a banking firm, the majority debtholders are
depositors, and by extension, the deposit insurance provider.
Finally, related to firm risk, firm size may influence the relationship between
corporate governance and risk-taking behavior (Aggarwal and Samwick, 1999;
Williams and Rao, 2006). Bank mergers typically involve larger firms than industrial
MF mergers, and banking firms may have more information outstanding (John and Qian,
2003). More importantly, banks may have incentives to take more risk as they become
34,5 larger. Banks do not experience financial distress and bankruptcy in the manner of
other firms – regulators are responsible for diagnosing and unwinding failing banks.
Also, large banks are often considered to be ‘‘too big to fail’’ in a regulatory sense, and
managers may therefore be more likely to engage in risky behaviors after mergers that
increase their bank’s size (Kane, 2000). Kaufman (2003) discusses the implicit
320 guarantees that have been afforded large US financial institutions by regulators and
the resulting legislation. It remains true, however, that bankers may have incentives to
merge in order to increase the size of their bank, and the increase in size may give firms
reasons to increase risk within their regulatory framework.

3. Research method
Our study focuses on whether CEO stock option convexity affects subsequent
managerial choices of corporate asset risk as revealed in merger and acquisition
decisions at banks. As noted previously, managers may be hesitant to taking on risk
increasing projects in view of their personal risk aversion, but this attitude could be
modified with sufficient convexity in their option portfolio. Because mergers and
acquisitions have the potential to significantly alter the firm’s asset and risk structure,
these events represent a likely activity through which the risk-incentive effect of
managerial stock option holdings could manifest itself. This results in the following
testable hypothesis (expressed in alternate form):
Ha. The ratio of post-merger variance to pre-merger variance should be positively
associated with the sensitivity of CEO option holdings to volatility.
We test this hypothesis by regressing the ratio of post-merger stock return variance to
pre-merger stock return variance on the risk-incentive effect of CEO option holdings.
Changes in firm variance surrounding acquisitions are estimated by taking the ratio
of common stock return variance in the post-merger period to the corresponding
variance measure from the pre-merger period. The pre-merger variance is measured
over the 180-day period ending 30 days before the merger announcement date. The
post-acquisition stock return variance is measured over the 180-day period beginning
11 days after the completion date of the acquisition. In order to ensure that changes in
firm variance are not related to changes in the market variance, we subtract market
return variance from the stock return variance for corresponding pre- and post-
acquisition periods. The market variance is proxied by the variance of the CRSP
equally weighted portfolio returns (including dividends). Using this market-adjusted
variance, we then find the ratio of the post-merger variance to the pre-merger variance
of stock returns.
Testing this hypothesis also requires that we measure the risk incentive of CEO
stock option holdings (ROPT). Early studies in the area used simple measures of the
risk-incentive effect of stock options such as taking the proportion of stock options to
total compensation. Core and Guay (2002) conduct an extensive analysis of alternate
measures of stock option risk incentives and show that these alternative measures
rarely capture more than 50-60 per cent of variability in the ‘‘full information’’
sensitivity measure. They recommend the use of the ‘‘full information’’ sensitivity
measure defined as the partial of the B-S option value with respect to a 1 per cent
change in the annualized standard deviation of stock returns. In view of the potential
problems associated with simply using the dollar value of option values to capture the
risk-incentive effect, we follow Core and Guay’s recommended approach. This Bank mergers
approach also has been used by Williams and Rao (2006) and Rajgopal and Shevlin and CEO stock
(2002). Similar to these studies, we use the partial derivative of the CEO option
portfolio value to the standard deviation of the underlying stock returns to capture the options
risk-incentive effect of stock option. The partial derivative is estimated using the B-S
model to calculate the value of the CEO’s option holdings in the year prior to the merger
announcement. 321
The partials are calculated separately for previously issued stock option holdings
and for newly granted stock options in the year preceding the merger announcement.
Calculating the B-S option value for previously issued stock options is problematic
because firms do not disclose the exercise price for previously issued options; however,
we are able to back out the average exercise price using other information firms are
required to disclose. Once the option sensitivity to risk is estimated for the new and
previously granted options, they are weighted to produce a single estimate of the risk-
incentive effect for a given CEO[3].
We then scale the risk-incentive measure (ROPT) by the CEO’s total compensation
in order to permit cross-sectional comparisons between firms. Studies have shown that
compensation structure varies systematically by firm size, thus a scaling variable to
control for firm size is essential. Once the dependent variable (ratio of post-merger to
pre-merger volatility) and primary independent variable (risk incentive of CEO stock
option holdings) are obtained we test the hypothesis using Tobit regression analysis.
We use Tobit regression because the dependent variable is truncated, i.e. the ratio of
post- to pre-merger variance cannot be less than zero.
We control for other bank-specific risk influences by including measures of
regulatory capital and leverage. For capital, we use two measures: Tier 1 capital to risk-
weighted assets (a regulatory measure of credit risk exposure and capital adequacy) is
listed as RBC1 in subsequent tables, and total risk-based capital to risk-weighted
assets (a broader measure) is listed as RBC. To capture any effect of differing leverage
or liquidity risk, we include a measure of the bank’s deposit-to-asset ratio, LEV.
Finally, we include a measure of bank size. In studies of compensation, incentives
and performance, size is often used to proxy for a firm’s risk. It has special role in this
study: given regulatory incentives to become ‘‘too big to fail’’, we expect some bank
managers to be predisposed to increase risk after mergers, and this tendency should be
more recognizable with larger mergers.
The sample of bank mergers is compiled from the securities data corporation (SDC)
database. We identify all banks in the SDC database that have merged with other banks
from 1993 through 2002. Our initial sample size yields us 1,942 potential bank
acquisitions. For the acquisition to be included in the sample, the acquired firm’s
market equity capitalization has to be equal to at least 10 per cent of the acquiring
firm’s market equity capitalization four weeks prior to the announcement date. This
ensures that the transaction is likely to have a significant impact on the acquiring firm.
Of the 1,942 potential mergers, 893 of them meet the 10 per cent criteria. Another
requirement for inclusion of the acquiring bank in the sample is the availability of
stock return data to calculate the variance over the pre- and post-acquisition periods.
Finally, we consider only acquiring banks that have data available on the CEO’s
compensation in the Standard and Poor’s ExecuComp database (246 banks are found in
ExecuComp). After accounting for incomplete compensation and stock return data, we
have a final sample size of 131 bank acquisitions over the period.
MF 4. Discussion of empirical results
Table I presents descriptive statistics for our merger sample, which consists of 131
34,5 bank acquisitions between 1993 and 2002. Post-merger, the mean bank size, in total
assets, is $42.582 billion (from $23.470 billion pre-merger). These banks have a mean
(median) return on assets of 1.06 per cent (1.13 per cent) post-merger, and a return on
equity of 13.55 per cent (14.34 per cent) afterwards; both measures of profitability
reflect only a minor change from the pre-merger levels. Across the event, mean
322 (median) deposits grew from $14.599 ($5.651) billion to $25.376 billion ($10.219). On
average, these banks experience a decline in non-performing assets, a decrease in
regulatory capital (as measured by total risk-based capital to risk-weighted assets),
and a decline in leverage (as measured by the deposit ratio) across the merger event[4].
In addition, on average the loan portfolio becomes a larger component of total assets
due to the merger.
Table II describes the compensation levels observed in the sample. The mean
(median) total compensation of the bank’s CEO is $2.576 million ($1.558 million). Total
compensation is defined as the sum of salary, bonus, value of restricted stock grants,
long-term incentive payout plans, and value of new stock grants (note this definition of
total compensation excludes option grants). The mean (median) change in the CEO’s
option holdings for a 1 per cent change in the standard deviation of the underlying
stock returns is $317,370 ($209,820). Finally, the mean (median) ratio of post-merger
volatility to pre-merger volatility is 1.32 (0.99).
The increase in volatility relative to pre-merger levels noted above is inconsistent with
the acknowledged rationale for bank mergers: lowering within-firm correlation (DeLong,
2003). From the principle of portfolio diversification we know that the actual impact on
the combined firm’s stock return volatility will depend on the variance of the two firms

Pre-merger statistics Post-merger statistics

Mean Median Minimum Maximum Mean Median Minimum Maximum

Assetsa 23,470 9,034 567 194,716 42,582* 15,764 1,509 275,178

ROA (%) 1.03 1.09
0.32 1.81 1.06 1.13
0.08 2.02
Non-performing 0.67 0.53 0.00 6.39 0.51** 0.48 0.00 1.49
asset (%)
ROE (%) 13.75 14.39
5.82 20.33 13.55 14.34
2.44 25.12
Depositsa 14,599 5,651 420 100,470 25,376* 10,219 1,145 162,278
a
Debt 21,793 8,479 528 184,550 39,493* 13,837 1,370 255,436
Equitya 1,679 589 39 11,011 3,089* 1,197 80 21,337
RBC (%) 13.55 12.94 8.23 35.93 12.66* 12.28 10.00 18.12
RBC1 (%) 9.79 9.35 5.00 29.00 9.15 8.81 5.00 15.51
NLPD (%) 61.13 63.30 3.83 83.35 61.34 62.97 4.28 83.73
NLPA (%) 87.95 87.74 6.61 149.06 92.41*** 90.50 7.04 143.45
ONEYRR (%) 34.12 36.57
35.66 167.13 17.25* 14.78
47.26 129.50
Leverage (%) 70.53 72.07 24.72 88.76 67.08** 69.34 28.05 86.38

Notes: The bank merger sample size is 131. The announcement date for the mergers occur from 1993 to 2002.
Total assets, ROA, Non-performing assets as a percentage of total assets, ROE, Total deposits, Total debt, Total
equity, RBC (all regulatory capital/risk-weighted assets), RBC1 (Tier 1 regulatory capital/risk-weighted assets),
NLPD (net loans as a per cent of deposits), NLPA (net loans as a per cent of assets), ONEYRR (one year
return), and Leverage (total deposits/total assets) are measured the year prior to the announcement of the
Table I. merger and the year after the completion of the merger. The asterisks under the mean column for post-merger
Descriptive statistics for Statistics are used to denote if the mean values are significantly different from the corresponding values for
the bank merger sample pre-merger statistics.*,**,***Significant at the 1, 5, and 10 per cent level, respectively; aMeasured in millions
 Mean Median Minimum Maximum Bank mergers
and CEO stock
Salary 531.65 509.55 195.00 1,140.00 options
Salary (%) 32.99 31.75 6.23 73.01
Bonus 535.49 351.42 0.00 8,099.50
Bonus (%) 22.90 21.50 0.00 71.88
Other annual 19.48 0.00 0.00 345.09
Other annual (%) 0.61 0.00 0.00 8.12 323
RSTKGRNT 313.99 0.00 0.00 4,050.00
RSTKGRNT (%) 8.06 0.00 0.00 68.19
New OPT GRNT 907.21 414.70 0.00 8,991.58
New OPT GRNT (%) 26.74 22.64 0.00 80.43
LTIP 119.39 0.00 0.00 1,420.78
LTIP (%) 3.91 0.00 0.00 33.89
All OTH 148.97 41.19 0.00 4,223.81
All OTH (%) 4.80 2.64 0.00 64.51
Total COMP 2,576.17 1,558.36 321.88 13,973.27
Option sensitivity 317.37 209.82 12.95 2,706.99
Merger volatility 1.32 0.99 0.10 4.34
MV of equity 3,919.82 1,410.12 98.69 60,250.29

Notes: Salary, bonus, other annual compensation, restricted stock grants, value of new option
grants, long-term incentive payout plans, and all other compensation are reported for the year
prior to the announcement of the merger (in thousands of dollars). These compensation variables
are also presented as a percentage of total compensation. Total compensation (in thousands of
dollars) is the sum of salary, bonus, value of restricted stock grants, long-term incentive payout
plans, and value of new stock grants in the year prior to the merger. Option sensitivity (in
thousands of dollars) is the sensitivity of the option portfolio value to a 1 per cent change in
standard deviation that is also measured as of the year prior to the merger announcement. Merger
volatility is the ratio of the post-merger stock return variance to the pre-merger variance. The pre-
merger variance is measured over the 180-day pre-announcement period ending 30 days before the
merger announcement date. The post-merger variance is measured over the 180-day period Table II.
beginning 11 days after the completion date of the acquisition. Market value of equity is the value Descriptive statistics for
of the equity four weeks prior to the announcement of the merger bank CEO compensation

and the covariance of the target firm with the existing firms returns and also on the
relative weights of the two firms. In recent years, with the availability of new financial
services and products, banks have told regulators that within-firm reduction in risk was
a primary motivation for mergers (Koch and MacDonald, 2003). In our sample, it appears
that few banks experience a reduction in overall firm risk as the result of a merger.
Tests of our main hypothesis are presented in Table III. Panel A presents results for
a Tobit regression where the ratio of post- to pre-merger volatility is regressed on the
risk-incentive effect of CEO stock options, the size of the bank, an interaction term for
compensation sensitivity and size, the total risk-based capital ratio, and leverage.
The parameter estimates for the relationship between compensation sensitivity and the
ratio of post-merger to pre-merger volatility is positive and different from zero,
the estimated coefficient of bank size is positive and significant, and the interaction
term between size and compensation sensitivity is negative and different from zero.
As hypothesized, we find that greater convexity of stock option holdings is
associated with increased corporate risk taking within bank mergers. This is
consistent with the findings of Williams and Rao (2006) regarding industrial mergers.
MF Parameter estimate Chi-square P-value statistic
34,5
Panel A: Merger volatilityi ¼ 0 þ 1 ROPTi þ ROPT  SIZEi þ SIZEi þ RBCi þ LEVi þ ui
INTERCEPT
1.860 2.56 0.110
ROPT 0.226* 11.03 0.001
ROPT*SIZE
0.023* 10.00 0.002
SIZE 0.237** 5.35 0.021
324 RBC 0.025 1.97 0.160
LEV
0.620 1.52 0.220
Panel B: Merger volatilityi ¼ 0 þ 1 ROPTi þ ROPT  SIZEi þ SIZEi þ RBC1i þ LEVi þ ui
INTERCEPT
1.945*** 2.92 0.087
ROPT 0.238* 12.01 0.001
ROPT*SIZE
0.024* 10.73 0.001
SIZE 0.263** 6.50 0.011
RBC1 0.042** 3.91 0.048
LEV
0.994*** 3.32 0.069

Notes: Panel A presents Tobit regression results for the following regression model: Merger
volatilityi ¼ 0 þ 1 ROPTi þ ROPT  SIZEi þ SIZEi þ RBCi þ LEVi þ ui where merger volatility is
the ratio of post-merger volatility to pre-merger volatility. The independent variable, ROPT, is the
risk-incentive effect of CEO stock option holdings. ROPT is estimated as the partial of the B-S
option portfolio value (in thousands) for a 1 per cent change in the standard deviation of the
firm’s stock returns divided by total compensation. ROPT*SIZE is the interaction term between
the ROPT variable and firm size, the latter measured as the log of total asset size (in millions of
dollars) of the firm as of the fiscal year end before the merger announcement date. RBC is the
ratio of all regulatory capital to risk-weighted assets. LEV is the ratio of total deposits to book
value of assets. RBC and LEV are also measured as of the fiscal year end before the merger
announcement date. Panel B presents Tobit regression results for the following regression model:
Table III. Merger volatilityi ¼ 0 þ 1 ROPTi þ ROPT  SIZEi þ SIZEi þ RBC1i þ LEVi þ ui where RBC1 is
Tobit analysis for the the ratio of Tier 1 regulatory capital to risk-weighted assets as of the fiscal year end before the
bank merger sample merger announcement date. ***,**,*Significant at the 10, 5, and 1 per cent level, respectively

The inverse relationship between the volatility ratio and the interaction term is also
consistent with the results of Williams and Rao (2006). Here, however, firm size itself is
directly related to merger volatility as well.
The positive relation between volatility and size and the negative interaction
coefficient estimate leads us to suggest that the impact of CEO risk incentives on post-
merger volatility may be less of an influence on larger firms: as firm size increases, the
CEO’s risk incentives become less and less important in determining the risk of a
merger.
Panel B shows a second Tobit regression in which the Tier 1 risk-based capital ratio
is used instead of the more comprehensive measure. In this new specification, we
observe very little change with respect to the other parameter estimates, but the
negative leverage effect is now statistically significant, as is the Tier 1 capital ratio.
The differing results are likely due to the composition of the total risk-based capital
ratio, which can include subordinated debt, preferred stock, and other hybrid issues, all
carried at book value. Although this definition of ‘‘capital’’ may sound unusual, it is
accepted practice in bank regulation (see Koch and MacDonald, 2003). Tier 1 capital
contains, mainly, common equity and other closely related sources of risk capital, and
may more accurately reflect the differential capital risk faced by acquiring banks. The
positive relationships between ROPT and volatility and risk-based capital and
volatility confirm the supposition of prior work that compensation sensitivity may Bank mergers
serve as a substitute for capital regulation ( John et al., 2000). and CEO stock
The negative relationship between leverage (measured as the deposit ratio) and
post-merger risk is also intuitive – one reason that banks have traditionally merged is options
to obtain a larger (geographic) deposit base and to lower their liquidity risk, or
exposure to sudden deposit outflows due to rate changes (Kane, 2000). Historically, the
movement of consumer deposits has been largely interest rate neutral, and this pattern
of behavior combined with the recent ability to merge across regions fits well with at
325
least one traditional motive for bank mergers and the behavior of our sample banks[5].
For comparison, Table IV reproduces the regressions from Table III using ordinary
least squares regression rather than Tobit. The direction and magnitude of the
parameter estimates are qualitatively similar using OLS although the statistical
properties of the estimates are different.

Parameter estimate T-statistic P-value

Panel A: Merger volatilityi ¼ 0 þ 1 ROPTi þ ROPT  SIZEi þ SIZEi þ RBCi þ LEVi þ ui

INTERCEPT
0.626
0.41 0.684
ROPT 0.245  2.75 0.007
ROPT*SIZE
0.025**
2.59 0.011
SIZE 0.249*** 1.88 0.062
RBC 0.016 0.78 0.436
LEV
1.016
1.39 0.166
F-statistic 2.66** 0.025
Adjusted R2 0.060
Panel B: Merger volatilityi ¼ 0 þ 1 ROPTi þ ROPT  SIZEi þ SIZEi þ RBC1i þ LEVi þ ui
INTERCEPT
0.959
0.63 0.531
ROPT 0.265* 2.94 0.004
ROPT  SIZE
0.027*
2.76 0.007
SIZE 0.282** 2.11 0.037
RBC1 0.036 1.48 0.142
LEV
1.225***
1.69 0.092
F-statistic 3.01 0.013
Adjusted R2 0.072

Notes: Panel A presents OLS regression results for the following regression model: Merger
volatilityi ¼ 0 þ 1 ROPTi þ ROPT  SIZEi þ SIZEi þ RBCi þ LEVi þ ui where merger volatility is
the ratio of post-merger volatility to pre-merger volatility. The independent variable, ROPT, is the
risk-incentive effect of CEO stock option holdings. ROPT is estimated as the partial of the B-S
option portfolio value (in thousands) for a 1 per cent change in the standard deviation of the
firm’s stock returns divided by total compensation. ROPT*SIZE is the interaction term between
the ROPT variable and firm size, the latter measured as the log of total asset size (in millions of
dollars) of the firm as of the fiscal year end before the merger announcement date. RBC is the
ratio of all regulatory capital to risk-weighted assets. LEV is the ratio of total deposits to book
value of assets. RBC and LEV are also measured as of the fiscal year end before the merger
announcement date. Panel B presents OLS regression results for the following regression model: Table IV.
Merger volatilityi ¼ 0 þ 1 ROPTi þ ROPT  SIZEi þ SIZEi þ RBC1i þ LEVi þ ui where RBC1 is OLS regression analysis
the ratio of Tier 1 regulatory capital to risk-weighted assets as of the fiscal year end before the for the bank merger
merger announcement date.***,**,*Significant at the 10, 5, and 1 per cent level, respectively sample
MF 5. Conclusions
34,5 The agency literature recognizes that managerial risk aversion combined with
excessive concentration of managerial wealth in a single firm predisposes managers to
reduce risk to a less than optimal level. Following Williams and Rao (2006), this study
examines the role of CEO stock option holdings compensation in controlling such
behavior in banking firms. We examine bank mergers to determine if stock option
326 grants influence managerial choices of corporate assets with regard to their impact on
equity variance.
If stock options are useful in moderating CEO preference for lowering corporate risk,
we should find that CEOs with greater risk incentives in their stock option holdings
should be associated with greater subsequent equity return volatilities. Using a sample
of bank acquisitions completed between 1993 and 2002, we find that merger volatility is
directly related to the stock option risk incentive of bank CEOs. We control for size,
capital risk, and leverage, and find that firm size is positively related to merger volatility
as well. Additionally, we document that the stock option risk-incentive effect is
moderated for larger firms. Overall our results support the notion that stock options are
an effective means of motivating bank managers to alter their risk-incentive behavior.

Notes
1. The average total equity-to-asset ratios of merging firms in our sample are 7.15 per cent
pre-merger and 7.69 per cent post-merger. As reported in Table I, regulatory levels of
risk-based capital are somewhat higher.
2. As of 1991, all banks are required to hold capital according to the risk of their assets to
comply with the Federal Deposit Insurance Corporation Improvement Act (FDICIA) and
its interpretation of the Basle standards on risk-based capital.
3. Appendices A and B in Williams and Rao (2006) describe in detail the algorithm used to
derive the risk-incentive metric.
4. DeLong (2003), among others, notes short-term performance declines following bank
mergers, and the poor market returns around bank mergers are well documented (see
Kane, 2000).
5. Our sample includes the 1994-1997 period when the banking industry was in transition
from regional mergers to a national system following the passage of the Riegle-Neal Act
in 1994. Prior to this act, merger activity across geographic boundaries was often limited
to the purchase of distressed institutions or mergers within the context of regional
compacts (within the Southeast, for example).

References
Adams, R. and Mehran, H. (2003), ‘‘Is corporate governance different for bank holding
companies’’, Economic Policy Review, Vol. 9 No. 1, Federal Reserve Bank of New York,
pp. 123-42.
Aggarwal, R. and Samwick, A. (1999), ‘‘The other side of the tradeoff: the impact of risk on
executive compensation’’, Journal of Political Economy, Vol. 107 No. 1, pp. 65-105.
Agrawal, A. and Mandelker, G.N. (1987), ‘‘Managerial incentives and corporate investment and
financing decisions’’, Journal of Finance, Vol. 42, pp. 823-37.
Bliss, R. and Rosen, R. (2001), ‘‘CEO compensation and bank mergers’’, Journal of Financial
Economics, Vol. 61, pp. 107-38.
Carpenter, J.N. (2000), ‘‘Does option compensation increase managerial risk appetite’’, Journal of
Finance, Vol. 55 No. 5, pp. 2311-31.
Core, J. and Guay, W. (2002), ‘‘Estimating the value of employee stock option portfolios and their Bank mergers
sensitivities to price and volatility’’, Journal of Accounting Research, Vol. 40 No. 3, pp. 613-30.
DeFusco, R.A., Johnson, R.R. and Zorn, T.S. (1990), ‘‘The effect of executive stock option plans on
and CEO stock
stockholders and bondholders’’, Journal of Finance, Vol. 45 No. 2, pp. 617-28. options
DeLong, G. (2003), ‘‘Does long-term performance of mergers match market expectations?
Evidence from the US banking industry’’, Financial Management, Vol. 32 No. 2, pp. 5-25.
Guay, W.R. (1999), ‘‘The sensitivity of CEO wealth to equity risk: an analysis of the magnitude 327
and determinants’’, Journal of Financial Economics, Vol. 53 No. 1, pp. 43-71.
Hall, B. (1998), ‘‘The pay for performance incentives of executive stock options’’, working paper,
Harvard Business School, Boston, MA.
Haugen, R.A. and Senbet, L.W. (1981), ‘‘Resolving the agency problems of external capital
through options’’, Journal of Finance, Vol. 36 No. 3, pp. 629-47.
Hirshleifer, D. and Suh, R. (1992), ‘‘Risk, managerial effort, and project choice’’, Journal of
Financial Intermediation, Vol. 2, pp. 308-45.
Jensen, M.C. and Meckling, W.H. (1976), ‘‘Theory of the firm: managerial behavior, agency costs
and ownership structure’’, Journal of Financial Economics, Vol. 3 No. 4, pp. 305-60.
John, T. and John, K. (1993), ‘‘Top-management compensation and capital structure’’, Journal of
Finance, Vol. 48 No. 3, pp. 949-74.
John, K. and Qian, Y. (2003), ‘‘Incentive features in CEO compensation in the banking industry’’,
Economic Policy Review, Vol. 9 No. 1, Federal Reserve Bank of New York, pp. 109-21.
John, K., Saunders, A. and Senbet, L.W. (2000), ‘‘A theory of banking regulation and management
compensation’’, Review of Financial Studies, Vol. 13 No. 1, pp. 95-125.
Kane, E. (2000), ‘‘Incentives for banking megamergers: what motives might regulators infer from
event-study evidence?’’, Journal of Money, Credit and Banking, Vol. 32 No. 3, pp. 671-701.
Kaufman, G. (2003), ‘‘Too big to fail in U.S banking: Quo Vadis?’’, working paper, Federal Reserve
Bank, Chicago, IL.
Koch, T. and MacDonald, S. (2003), Bank Management, 5th ed., Thomson-South Western,
New York, NY.
Macey, J.R. and O’Hara, M. (2003), ‘‘The corporate governance of banks’’, Economic Policy Review,
Vol. 9 No. 1, Federal Reserve Bank of New York, pp. 91-107.
Murphy, K.H. (1998), ‘‘Executive compensation’’, working paper, Yale University, New Haven, CT.
Myers, S. and Majluf, N. (1984), ‘‘Corporate financing and investment decisions when firms have
information that investors do not have’’, Journal of Financial Economics, Vol. 13, pp. 187-221.
Rajgopal, S. and Shevlin, T. (2002), ‘‘Empirical evidence on the relation between stock option
compensation and risk taking’’, Journal of Accounting and Economics, Vol. 33 No. 2, pp. 145-72.
Smith, C.W. and Stulz, R.M. (1985), ‘‘The determinants of firm’s hedging policies’’, Journal of
Financial and Quantitative Analysis, Vol. 20 No. 4, pp. 391-405.
Tufano, P. (1996), ‘‘Who manages risk? An empirical examination of risk management practices
in the gold mining industry’’, Journal of Finance, Vol. 51 No. 4, pp. 1097-137.
Williams, M. and Rao, R.P. (2006), ‘‘CEO stock options and equity risk incentives’’, Journal of
Business Finance & Accounting, Vol. 33, pp. 26-44.

Corresponding author
Melissa A. Williams can be contacted at: williamsmeli@cl.uh.edu

To purchase reprints of this article please e-mail: reprints@emeraldinsight.com

Or visit our web site for further details: www.emeraldinsight.com/reprints