Financial Market Developments and Management Compensation

Transcription

1 Financial Market Developments and Management Compensation Daniel Bens INSEAD Scott Liao Rotman School of Management University of Toronto Barbara Su Rotman School of Management University of Toronto February 6, 2017 We thank Anil Arya, Anne Beatty, Peter Demerjian (discussant), MingCherng Deng (discussant), Bjorn Jorgensen, Rick Johnston, Rachel Hayes, Steve Monahan, Darren Roulstone, Bharat Sarath and seminar participants at the University of Groningen, the Ohio State University, Bocconi University, London School of Economics, Cass Business School City University London, WHU-Otto Beisheim School of Management, Miami University, University of Toronto, the INSEAD Accounting Symposium, the 26th Annual Conference on Financial Economics and Accounting (CFEA), the 2016 FARS conference and the 2015 CAAA annual conference, for their valuable comments and suggestions. We also thank Scott Dyreng for sharing the subsidiary data.

2 Abstract: We examine how the properties of executive compensation contracts change following a significant shift in the financing opportunities faced by nonfinancial firms. Specifically, we assess whether the branching provisions in the Interstate Banking and Branching Efficiency Act (IBBEA) affect borrowing firms use of stock options in executive compensation. Using the hand-collected compensation data of firms with market capitalization less than $75 million, we find that nonfinancial firms are likely to increase the use of stock options after IBBEA and that this increase is more pronounced for firms located in states with lower regulatory branch entry barriers. We further find that the increase in stock option use is more pronounced in states where the diversification benefits to the banks are the greatest. These findings suggest that with banks enhanced ability to diversify credit risk geographically and their increased tolerance for borrowers risk-taking, their clients nonfinancial firms adjust their compensation contracts that are previously constrained by bank distaste for risk. These findings not only suggest macro financial market developments affect firm corporate governance in this case compensation structures they also help us broaden our understanding of how financial market developments affect firm investment and innovation. Keywords: Compensation; Corporate Governance; Debt Contracting; Regulation

3 1. Introduction Based on John and John s (1993) argument that agency conflicts between creditors and shareholders constrain risk incentives provided in management compensation, it is surprising that little is known about whether and how financial market development that shapes banks loan portfolios and risk management affects nonfinancial firms (the clients of the banks) compensation schemes. This important omission is consistent with Demirgüç- Kunt and Maksimovic s (1996) observation that while prior research indicates how specific market imperfections affect firm corporate policies, there has been little work on the effect of the level of development of the financial markets on the firm s policies. To address this void, we examine the effect of bank deregulation on nonfinancial firms management risktaking incentives in executive compensation. 1 Specifically, we examine whether nonfinancial firms increase the use of stock options in executive compensation after the Interstate Banking and Branching Efficiency Act (IBBEA). As summarized by Levonian (1994) and Johnson and Rice (2008), IBBEA allowed banks to expand operations across states and thus better diversify deposit taking and lending geographically. We contend that banks better ability to diversify credit risk may lower agency conflicts over risk-taking between banks and borrowers and thus reduce banks demand for price protection against risk incentives embedded in borrower executive 1 Frydman and Jenter (2010) provide a comprehensive review of the recent CEO compensation literature, and conclude that many unanswered questions exist about whether compensation is dominated by rents from managerial moral hazards versus the results of a competitive labor market. For example, on this debate, Yermack (1995) finds that agency or financial contracting theories do not explain executive compensation, suggesting that compensation committees may not respond to this shock to external financing opportunities arising from banking deregulation. As a result, whether bank deregulation affects firm management compensation practices of bank clients is an empirical question. 1

4 compensation. Nonfinancial firms can take advantage of this lower agency cost of debt by improving management-shareholder alignment that is previously constrained by the agency conflicts of debt. 2 Based on this argument, we argue that nonfinancial firms may increase the use of stock options after IBBEA. While IBBEA involves both interstate banking and branching deregulations, we focus on the interstate branching provisions because the effect of IBBEA interstate banking deregulations was largely preempted as virtually all states had allowed interstate banking before IBBEA. 3 We further rely on the fact that different states relax interstate branching restrictions at different times and to varying extents as our main identification strategy in the difference-in-differences research design. Specifically, IBBEA grants states the right to erect roadblocks to branch expansion across the state lines, thereby giving rise to significant cross-sectional differences in the effect of branching deregulation. For example, in addition to allowing states to decide whether they permit partial acquisitions of a bank, IBBEA also permits states to forbid out-of-state banks from opening new branches, mandate age restrictions on target banks in acquisitions, and limit the amount of total deposits any one bank can hold. These regulatory barriers impair banks ability to expand and to diversify loan portfolios geographically. As a result, we predict that firms in states 2 The argument that management-shareholder alignment is constrained by agency costs of debt is consistent with Murphy (2013) who argues that risk incentives are overall underprovided. 3 The literature in this area uses the term interstate banking to refer to acquiring or establishing chartered banks across state lines. The term interstate branching refers to the opening or acquisitions of individual branches across state lines or converting acquired out-of-state banks into branches. Most states allowed interstate banking starting from the late 1970s through the 1990s before IBBEA, predating the availability of data provided by EDGAR and DealScan required for the analysis. Therefore, we are not able to study the effect of interstate banking deregulations. This is also consistent with Rice and Strahan (2010) who argue that allowing interstate branching was the watershed event of IBBEA. Interstate branching allows banks to be more selective about the geographic scope of expansion, as well as its scale. 2

5 with higher regulatory barriers are less likely to increase risk incentives in management compensation compared to states with fewer restrictions. 4 We employ a hand-collected sample of 282 firms with market capitalization less than $75 million (1,719 firm-year observations). We use this sample because these firms are likely to depend on local loan financing and therefore most affected by bank geographic deregulation. 5 Before testing our hypotheses, we validate that banks increase diversification of their loan portfolios across state lines after IBBEA and that these small firms increase their borrowings from out-of-state banks that open new branches in the same state and local banks that expand across state borders. Further, to validate the assumption that banks are more risk tolerant and reduce price protection against risk incentives subsequent to IBBEA due to increased geographical diversification, we find that the association between interest charges on loans and stock options decreases after IBBEA. In our main analysis, we find that these small nonfinancial firms increase the use of stock options after IBBEA takes effect in the state where the firm is located and that this increase is more pronounced in firms headquartered in states that have lower regulatory entry barriers, compared to those in states with higher barriers. These findings are consistent with the notion that firms increase risk-taking incentives in compensation contracts to encourage management risk-taking at lower agency costs of debt after bank 4 The reciprocity provision in most states suggests that banks located in states that impose more branching restrictions would be more limited in diversification. 5 We focus on firms with market capitalization less than $75 million because such firms likely lack bargaining power with banks, and they have less ability to borrow from banks in other geographic markets compared to larger firms. 3

6 geographic deregulation. These results also suggest that firms managerial compensation policy is affected by the financial market development at the macro level. To provide further evidence that nonfinancial firms increased use of stock options results from banks improved loan diversification subsequent to the interstate branching deregulations, we conduct two cross-sectional analyses based on economic comovements. In the first analysis, we partition states according to the comovements in economy with the rest of the US. We expect that if a state s economic activity is less correlated with the economic production of other states in the country, the deregulation would provide greater diversification benefits for entering banks and local banks expanding across state borders; firms in these states should have a larger increase in risk incentives in their management compensation contracts. Similarly, we also investigate whether the increase in stock option use is more significant when the new entering banks are from states where economic activities comove less with the state in question. Consistent with our expectations, we find that the increase in the use of stock options around IBBEA interstate branching reforms is more pronounced when the economy of the state in which the firm is located comoves less with the rest of the US and with the states where the new entering banks are from. These findings suggest that the enhanced credit risk diversification for entering banks and local banks that expand across state borders explains the linkage between bank deregulation and the use of stock options in management compensation. In addition to these cross-sectional analyses based on bank diversification benefits at the state level, we further expect that the effect of bank deregulation on firm risk-taking 4

7 incentives should be the strongest for potential borrowers that are most likely to benefit from bank diversification. To examine this possibility, we partition the sample of borrowers by whether the firm had issued public debt, whether the firm had entirely borrowed from local lenders before IBBEA, and firm size. We find the effect of interstate branching deregulation on the use of stock options to be greater for firms that had not issued public debt, for firms that had entirely borrowed from local banks before IBBEA, and for smaller firms. These findings are consistent with the notion that firms that are more likely to rely on loan financing from local banks better exploit the diversification benefits from out-ofstate banks entries to the local market and local banks expansions to other states. As a control for the endogenous nature of regulation, we consider the possibility that the extent and timing of deregulation is caused by the economic conditions of the state as well as the political influences of small banks that likely oppose the new laws in the pre- IBBEA period. These factors can affect the timing and the extent of deregulation in a state and may also affect firm debt financing and compensation simultaneously. However, we do not find significant differences in changes in the use of stock options in management compensation between states with high versus low pre-deregulation economic growth, between high versus low proportions of small banks, or between high versus low state population. More importantly, our main results continue to hold when we control for these endogeneity considerations. In addition, we conduct falsification analyses by assigning pseudo-deregulation years within two years before and two years after the actual enactment year in each state. We do not find significant changes in the use of stock options around 5

8 these pseudo-deregulation years, suggesting that our results are not caused by general time trends or the factors that may affect the timing and the extent of deregulation. In a supplemental analysis, to understand the consequences of the change in compensation contracts, we find that firms with a higher increase in the use of stock options around IBBEA incur more R&D investments and file for more patents. We also find this increase in investment and innovations to be more significant when the firm increases its borrowing from local banks after IBBEA. Finally, in a robustness check, we remove hightech firms, the results continue to hold, suggesting our findings are not driven by the boom of stock options in the high-tech sector. This study contributes to multiple literatures. First, it contributes to the literature on the relation between macro financial market structures and firm operations. In addition, our study is one of the first documenting that financial market development has a direct impact on compensation contracts, thereby contributing to the corporate governance literature. Cuñat and Guadalupe (2009) find that banking deregulation enhances incentive compensation within the financial services industry. Yet our focus is on how this deregulation affects the compensation structure of the clients (i.e., borrowers) of these banks. This study also broadens our understanding of the determinants of management compensation, in particular risk-taking incentives. Further, our study contributes to the literature on the interaction between agency conflicts of debt and management compensation, e.g., John and John (1993) and Ortiz- Molina (2007). Most empirical studies in this literature are subject to the difficulty in 6

9 identification due to simultaneity between debt financing and compensation structures. 6 Our study addresses this identification issue by exploiting exogenous banking deregulation. Our study suggests that when the agency cost of debt decreases as a result of increased credit risk diversification by lending banks, firms can improve management-shareholder alignment by providing more risk-taking incentives to executives. Our findings also shed light on the current debate on whether bank deregulation affects firm innovations as we examine the intermediate mechanism of the compensation contract. While Amore et al. (2013) argue that firms increase innovation activities after bank geographic deregulation, Hombert and Matray (2016) document a negative association between bank geographic deregulation and firm innovation. While the purpose of this study is not to reconcile the differences in these findings, we believe the effect of the executive compensation on risk-taking and how compensation contracts might change during bank deregulation, make compensation an important intermediate link between bank deregulation and firm risk-taking and investment activities. The remainder of the paper is organized as follows. Background information and literature review are provided in Section 2. The hypothesis development is presented in Section 3. We describe our research design in Section 4. Section 5 reports descriptive statistics, empirical findings and additional analyses. Conclusions are drawn in Section 6. 6 Past research has examined whether management incentives in compensation affect the agency cost of debt, e.g., Begley and Feltham (1999) and Ortiz-Molina (2006). While the findings in these studies are consistent with John and John (1993), they face the same econometric challenge in addressing simultaneity. 7

10 2. Background and Literature Review 2.1 Evolution of Banking and Branching Deregulations Johnson and Rice (2008) note that the 1927 McFadden Act prohibited the branching activities outside of the city where the national bank was situated, and more importantly, by reference, this Act restricted any intrastate or interstate branching activities. Some states relieved intrastate branching restrictions partially or entirely starting from the 1930s through the 1970s. In 1970, only 12 states allowed unrestricted statewide branching while another 16 states prohibited branching entirely. After 1970, 38 states gradually eased intrastate branching restrictions through Rice and Strahan (2010) discuss that intrastate branching reforms usually occurred in a two-step process. States first permitted multi-bank holding companies to convert subsidiary banks into branches and later permitted de novo branching where banks could open new branches within the state. In addition to intrastate and interstate branching restrictions, states also once prohibited interstate banking. The Douglas Amendment to the 1956 Bank Holding Company Act prohibited a bank holding company from acquiring banks outside the state where it was headquartered unless the target bank s state permitted such acquisitions. The first state that relaxed interstate banking acquisition restrictions is Maine in 1978, which was not reciprocated by any state until Alaska and New York passed similar laws in While all states but Hawaii continued to alleviate this interstate banking (i.e., acquisition or establishment of a chartered bank across state borders) restriction through 1992, virtually no state had allowed banks to open branches across state lines. 7 7 While eight states allowed limited interstate branching prior to IBBEA of 1994, it was not exercised in these states except for a few cases (Rice and Strahan, 2010). 8

11 The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (IBBEA) formally repealed the Douglas Amendment and the McFadden Act provisions. It completed the interstate deregulation by allowing bank holding companies or banks to enter other states by operating branches. This potential mode of individual branch expansion offered banks more flexible options about the scale and geographical scope of growth versus the acquisition or establishment of an entire bank in another state that requires separate management and governance and must meet bank regulations on a standalone basis. That is, interstate branching deregulations provide a significantly less costly means for banks to expand across state borders and greatly enhance the potential of bank diversification in operations geographically. Subsequent to interstate branching deregulations, the number of multi-state banks rose from only 10 in 1994 to 387 in 2005 (Kroszner and Strahan, 2013). Johnson and Rice (2008) also find that the number of out-of-state branches increases from 62 in 1994 to 24,728 in These findings suggest banks greatly exploit this branching deregulation to expand geographically. To validate that IBBEA branching deregulation does affect the loan portfolios geographically, in Appendix A-1, we find that in the post IBBEA period, bank diversification in lending across states, measured as Herfindahl index of loans to clients across states, increases with diversification in deposits, measured as Herfindahl index of deposits across states. In addition, in Appendix A-2, we find a significant decrease in Herfindahl index of lending across states from 69% to 41% for banks that expand deposit operations across state lines after IBBEA. This change is significantly higher than banks that do not expand operations across states. These findings together suggest that IBBEA 9

12 branching deregulations enhance bank lending diversification geographically. That is, as banks diversify deposit taking across states after IBBEA, banks also diversify their loan portfolios geographically because they are better able to reach out to borrowers in other states, especially those that rely more on local banks. Consistent with this validation and the notion that small nonfinancial firms have access to loan capital provided by banks headquartered in other states subsequent to IBBEA, we observe in Appendix B that the proportion of loans provided by out-of-state banks that subsequently have branches in the same state as the borrower in the post period increases from 14% to 31%. In addition, the proportion of loans provided by local banks that subsequently expand operations to other states post IBBEA also increases from 40% to 47%. This is a stark comparison with the proportion of loans provided by local banks that stay local after IBBEA, which decreases from 17% to 1%. Borrowers of out-of-state banks that expand into the local market and local banks that expand to other states are likely to benefit the most from the bank geographic deregulations. While IBBEA allows banks to operate branches across state borders, it grants states the right to erect roadblocks by forbidding out-of-state banks from opening new branches, mandating age restrictions on target banks in acquisitions, restricting whether out-of-state banks can acquire individual branches, and limiting the amount of total deposits any one bank can hold in the state. Details of these restrictions on a state by state basis are provided in Appendix C. These barriers significantly impair the effectiveness of deregulation and banks ability to diversify their loan portfolios geographically. Consistent with this notion, Johnson and Rice (2008) find that states with greater restrictions have fewer interstate 10

13 branches as a share of total branches. We rely on variations in (1) the timing of relaxing interstate branching restrictions, and (2) regulatory barriers across states as our main identification strategy to examine the effect of bank interstate branching reforms on nonfinancial firms use of stock options in executive compensation. 2.2 Relation between Management Compensation and Debt Financing Our study builds on the literature on the interaction between the agency conflicts of debt and management-shareholder alignment. John and John (1993) model an optimal management compensation scheme that depends on the capital structure and agency conflicts between debt and equity holders. They argue that while risk incentives provided in executive compensation contract improve management-shareholder alignment, these risk incentives would exacerbate agency conflicts of debt. As a result, the contractual form of management compensation is constrained by this agency cost of debt. Consistent with this, Murphy (2013) argues that firms are usually too conservative in providing risk incentives. In this study, we argue that when banks are able to diversify away credit risk geographically, the constraint to align the interest between management and shareholders is partially relieved and firms can therefore provide more risk incentives to management at a lower agency cost of debt. In support of this argument, Ortiz-Molina (2007) finds that firms are less likely to encourage risk-taking via compensation when they are leveraged by straight-debt compared to convertible debt, suggesting that firms trade off shareholder-manager alignment to mitigate the agency conflicts between equity and debt holders. In contrast, Yermack (1995) finds that neither agency nor financial contracting theories explain the use 11

14 of stock options. One econometric challenge faced by these studies that may give rise to the inconsistency of findings in this literature is that compensation and capital structure arise endogenously. This econometric concern also arises in previous research that documents that riskinducing management compensation increases the agency cost of debt. Consistent with John and John (1993), Begley and Feltham (1999) find that the use of debt covenants increases with managerial ownership, suggesting that the agency conflicts between shareholders and debtholders increase with management incentives of risk-taking. In addition, DeFusco et al. (1987) show that stock option grants are accompanied by a significant positive stock and a negative bond market reaction, supporting the notion that increased managerial risk-taking incentives may benefit shareholders at the expense of bondholders. Finally, Ortiz-Molina (2006) finds that the cost of debt increases with option holdings and pay-risk sensitivities in management compensation. Our study makes contributions to this body of research by using an exogenous instrument at the macro-level, i.e., banking industry reforms, to document the causal relation between debt financing and management compensation. One important underlying assumption in this paper is that banks would provide more favorable loan terms to individual borrowers after IBBEA at the same risk level when they diversify credit risk geographically. To validate this assumption, we examine whether banks reduce price protection against risk pre-committed by the use of stock options in 12

15 management compensation subsequent to IBBEA. 8 Appendix D shows results consistent with this assumption. We find that while the number of options is positively correlated with interest rates on loans (consistent with prior research such as Ortiz-Molina, 2006), this positive correlation decreases after IBBEA, suggesting that banks appear to reduce price protection against management risk-taking incentives after IBBEA takes effect due to their enhanced ability to diversify their loan portfolios and lower agency conflicts on risk-taking. With this result established, we turn to our main research question, which is whether the use of equity incentive compensation by borrowing firms increases when the geographic diversification strategy of lending banks allows for more risk tolerance. 2.3 Geographic Proximity and Loan Financing We expect the bank diversification effect on firm compensation to be more important for firms that were more likely to borrow from local banks that are less diversified before IBBEA. Following IBBEA, these firms can take advantage of bank diversification by borrowing from out-of-state banks entering in their local markets or local banks that expand operations to other markets as demonstrated in Appendix B. Previous research documents that firms, especially those with opaque information environments, tend to borrow from banks with close proximity to mitigate information problems. For example, Hauswald and Marquez (2006) argue that distance erodes a bank s 8 We estimate an OLS regression, where we regress LogSpread (the interest premium over LIBOR plus fees paid to the bank group), on NumOptions (the number of stock option grants), controlling for other variables known to affect loan pricing (e.g., Beatty et al., 2002). The data on loans are obtained from the LPC Dealscan database. We restrict our sample to firms that have borrowed at least once both in the pre- and post-ibbea periods to ensure that our results are not driven by the change in sample composition, and therefore the sample size declines significantly for this analysis. We include loan facilities in the period from three years before to three years after IBBEA enactment in each state to be consistent with the main analyses. 13

16 ability to collect borrower specific information when evaluating borrowers in the lending process. This is particularly important for opaque firms with high information asymmetry. In addition, Agarwal and Hauswald (2010) argue that both borrower proximity and preexisting business ties act as complements in information production because they facilitate the collection and interpretation of subjective soft information. 9 According to these arguments, we focus on small firms due to their reliance on local bank financing, which is most affected by branching reforms. In addition, in supplemental analyses, we partition our sample by firm size, whether they have access to the public debt market, and whether they exclusively rely on local banks as their debt capital providers. We expect that small firms, firms that do not have access to public debt, and firms that rely on local banks are more likely to benefit from the deregulations and therefore should experience a larger increase in option grants. 2.4 Banking Deregulation and Firm Investment and Innovation Previous research on the relation between bank geographic deregulation and firm investment and innovation has been mixed. For example, Amore et al. (2013) find that publicly traded firms benefit from increased bank geographical diversification arising from the interstate banking deregulations by increasing the quantity and quality of their innovation activities. They document that this increase in innovation is more significant for firms dependent on external capital and located closer to entering banks. This suggests that publicly traded firms are also affected by these banking reforms because banks 9 They further argue that technological progress applied to lending due diligence can only partially substitute for the natural limits to local-information gathering over greater distances, suggesting that the information advantage of local lenders persists despite the improved technology of larger, distant banks and their ability to harden soft information. 14

17 diversification benefits can be passed along to all borrowers, publicly traded or not. In contrast, using the same deregulation events, Hombert and Matray (2016) find opposite results based on the argument that geographic deregulations potentially reduce relationship lending that fosters innovation. Interestingly, Cornaggia et al. (2015) find that interstate branching deregulations decrease innovation based on the argument that competition enables small, innovative firms to secure financing instead of being acquired by public corporations. That is, banking competition reduces the supply of innovative targets for large publicly traded firms to acquire. While we do not attempt to reconcile these inconsistencies, our study provides insights into this debate by taking a different approach of examining the intermediate mechanism between bank deregulation and firm risk-taking: management compensation. Specifically, we study this question with a focus on how bank deregulation affects risk incentives embedded in nonfinancial firms compensation schemes. 3. Hypothesis Developments As discussed in previous sections, IBBEA interstate branching deregulations allow out-of-state banks to operate branches across state-lines and spur interstate bank acquisitions. One important consequence of this deregulation is that banks are better able to diversify their loan portfolios geographically as demonstrated in Appendix A. However, IBBEA also allows each state to impose differential restrictions on how out-of-state banks are allowed to enter the local market as discussed in Section 2. This creates variations in bank geographic diversification among states. 15

18 We posit that due to this enhanced geographic diversification of loan portfolios after IBBEA, banks can better diversify credit risk and reduce their price protection against individual firms pre-committed risk-taking incentives. As a result of decreased agency conflicts over risk-taking, borrowing firms can increase risk incentives in management compensation to further management-shareholder alignment that was previously constrained by agency conflicts of debt. In addition, as firms in less restrictive states are better able to take advantage of new entering banks diversification benefits, we expect the increase in risk incentives such as stock options in management compensation to be more pronounced in states with fewer restrictions. Accordingly, our first two hypotheses are as follows. H1: Firms increase risk incentives in management compensation subsequent to IBBEA. H2: The increase in risk incentives in firm management compensation after IBBEA is more pronounced in states with fewer restrictions than those with more restrictions. To enhance our causal interpretation of the empirical results of H1 and H2, we use an additional layer of identification in our analyses. If increased bank diversification caused by IBBEA interstate branching deregulations allows firms to increase risk incentives in management compensation, then this increase should be more pronounced in states where the economy is less correlated with the rest of the US because new entering banks into the state of interest or local banks expanding into other states can better diversify their credit risk geographically. Similarly, the increase in risk incentives should be more significant when the new out-of-state banks are entering from the states where the economy comoves less with the state of interest. We summarize these predictions in the third hypothesis as follows. 16

19 H3: The increase in risk incentives in firm management compensation after IBBEA is more pronounced in states where the benefit of diversification to banks is the greatest. 4. Sample and Research Design 4.1 Data and Sample Selection We use a hand-collected compensation dataset to study the effect of IBBEA on management compensation. We restrict our sample to firms with market capitalization under 75 million because smaller firms are more likely to borrow from local banks and therefore are more affected by IBBEA. 10 For example, these firms are less likely to rely on public debt: only 25% of them issued public debt at least once in the pre-deregulation period (untabulated). In addition, 83% of these firms do not have subsidiaries in a different state, thereby providing a cleaner test for our purpose because they are less likely to borrow from banks in states of the subsidiaries (untabulated). 11 This sample selection is consistent with prior banking deregulation research that mostly focuses on small firms, e.g., Chava et al. (2013). We only include firms covered by Dealscan to ensure that our sample firms use bank loan financing and therefore are likely to be affected by banking deregulations. We go through company proxy state statements from three years before to three years after the deregulation and collect the CEO compensation data from the Summary Compensation Table. We focus on this time period around deregulation, instead of all available data, to better identify the impact of bank deregulation on firms compensation structure and 10 Our sample is significantly smaller than the Compustat universe. The average market capitalization in 1994 is $39 million for our sample versus $847 million for the Compustat universe. 11 In a robustness check, the results continue to hold or become stronger when firms with multi-state subsidiaries are excluded from the sample. 17

20 mitigate the effect of the changes in the economic environment (e.g., the latest financial crisis) and other regulations that affect management compensation (e.g., FAS123R). We obtain accounting data from Compustat, and bank branch location and other bank specific data from the annual Summary of Deposits (SOD) surveys of the Federal Deposit Insurance Corporation (FDIC). In addition, we exclude financial firms from the sample. Following Heider and Ljungqvist (2015), we correct the historical firm headquarter locations provided in Compustat using headquarter states reported in the SEC filings. We also require a firm to have at least five years non-missing data to ensure that our results are not driven by the change in sample composition. After imposing these data restrictions, our final sample in the main analyses includes 282 firms (1,719 firm-year observations). 4.2 Model Specifications To test H1, we estimate model (1) below to investigate the change in firms option grants around IBBEA. Option Grants = β 0 +β 1 Post+β 2 FirmSize+β 3 ROE+β 4 Leverage+β 5 MarketBook +β 6 CashComp+β 7 AnnualRet+β 8 EarnVol+β 9 StockVol + Industry Fixed Effects + State Fixed Effects + Year Fixed Effects + ε (1) We focus on option grants as a measure of risk incentive in executive compensation based on the argument in previous literature that stock options incentivize management to take on risks. 12 The outcome variable is either (1) an indicator variable for whether the firm grants CEO stock options in a certain year in a probit model or (2) the natural log of the 12 Prior research suggests that executive stock option plans have asymmetric payoffs that should induce managers to take on more risks (Agrawal and Mandelker, 1987; DeFusco et al., 1990). 18

21 number of option grants in an OSL estimation. Post takes on the value of one for the period after the deregulation in the state where the firm is headquartered, and zero otherwise based on the timeline provided by Johnson and Rice (2008). Based on H1, we expect the coefficient on Post to be positive. We also follow prior compensation literature (e.g., Ortiz- Molina, 2007; Gao, 2010; Hayes et al., 2012) by controlling for firm size, return on equity, firm leverage, market to book ratio, CEO cash compensation, annual stock return, earnings volatility, and stock return volatility. We include industry, state, and year fixed effects to control for the unobserved heterogeneity across industries, states and time. The definitions of all variables can be found in Appendix E. As discussed in previous sections, in addition to the differing years in which IBBEA was imposed across states, we also rely on the variation in the regulatory barriers to interstate branching among states for our difference-in-differences analysis. Specifically, to test H2, we estimate model (2): Option Grants = β 0 +β 1 Post+β 2 LessRestr+β 3 Post LessRestr +β 4 FirmSize+β 5 ROE +β 6 Leverage+β 7 MarketBook+β 8 CashComp+β 9 AnnualRet +β 10 EarnVol+β 11 StockVol + Industry Fixed Effects + State Fixed Effects + Year Fixed Effects + ε (2) In model (2), we interact Post with LessRestr to test whether the increase in the use of stock options after IBBEA is greater in less restrictive states. LessRestr is measured as an indicator variable equal to one for firms located in less restrictive states, and zero otherwise, where restrictiveness is measured based on the index provided in Johnson and Rice (2008). They construct the restrictiveness index based on the four important provisions on interstate branching in each state: (1) the minimum age of the target 19

22 institution, (2) de novo interstate branching, (3) the acquisition of individual branches, and (4) a statewide deposit cap. They assign a value of one for each factor to the states that set more restrictive provisions, and then aggregate the four factors to obtain an overall measure of restrictiveness for each state. See Appendix C for the restrictiveness index of each state. The measure by construction ranges from zero to four with zero being the least restrictive and four being the most restrictive. We classify states with a restrictiveness index between zero and two as less restrictive states and LessRestr is equal to one for firms located in these states; those with the index between three and four are classified as more restrictive states and LessRestr equals zero for firms in these states. Based on H2, we expect the coefficient on Post LessRestr to be positive. To test H3 on whether the effect of IBBEA on compensation depends on geographic credit risk diversification, we estimate model (3): Option Grants = β 0 +β 1 Post+β 2 Diversification+β 3 Post Diversification +β 4 FirmSize +β 5 ROE+β 6 Leverage+β 7 MarketBook+β 8 CashComp+β 9 AnnualRet +β 10 EarnVol+β 11 StockVol + Industry Fixed Effects + State Fixed Effects + Year Fixed Effects +ε (3) In model (3), we interact Post with Diversification to test whether the increase in the use of stock options after IBBEA is more significant in states where banks can better diversify their credit risk. Diversification is a rank variable based on two measures of new entering banks diversification benefits. Specifically, similar to Amore et al. (2013), we measure diversification benefits based on (1) the US/state economic output correlation and (2) the new branches/state economic output correlation. The detailed descriptions of each partition and the corresponding prediction are explained as follows: 20

23 (1) The US/state correlation refers to the co-movement in the economy between the state of interest with the rest of US, calculated as the correlation of the state s monthly coincident index with the US coincident index for the past 10 years before the enactment of IBBEA ( ). 13 Diversification1 is measured as the inverse quintile ranking of the correlation. Based on the argument that banks are likely to have greater diversification benefits in the states where the economy has a lower co-movement with the other states in the US, we expect the coefficient on Post Diversification1 in model (3) to be positive, suggesting that the increase in the use of stock options is greater for the firms located in these states. (2) The new branches/state correlation refers to the weighted average of the comovements of the economies between the state of interest and the states where out-of-state branches entered from. The measure is estimated as follows. (i) We first estimate the pairwise correlation of the monthly coincident indices between all the states from 1984 to (ii) We next compute the weight assigned to each pair between the state in question and the state of entering banks. Specifically, for each home state p, we compute the percentage of the new branches entering from banks in state qi over the total number of out-of-state branches in state p for the period between June 1994 and June (iii) We use the ratio of the number of new branches from state qi over the total number of out-of- 13 The index is obtained from the Federal Reserve Bank of Philadelphia. The coincident index combines four state-level indicators to summarize current economic conditions in a single statistic. The four state-level indicators include nonfarm payroll employment, average hours worked in manufacturing, the unemployment rate, and wage and salary disbursements deflated by the consumer price index (U.S. city average). See the website of Federal Reserve Bank of Philadelphia for more details We identify out-of-state branches using the data from Summary of Deposits (SOD) surveys of the FDIC. A branch is identified as an out-of-state branch if data item stalp (the bank s headquarter state) is different from stalpbr (the state in which the branch is physically located). 21

24 state branches in state p from (ii) as a weight for the co-movement between state qi and state of interest (state p) to calculate the weighted average of the co-movements with all qi. Diversification2 is measured as the inverse quintile ranking of the weighted correlation. A lower correlation represents that the new out-of-state branches come from states that have lower commoving economic indicators with the state of interest, suggesting greater diversification benefits for the entering banks. Based on H3, we expect the coefficient on Post Diversification2 to be positive, consistent with the notion that the increase in option grants is more significant in states that have lower correlations with other states where the new entering banks come from. 5. Empirical Results 5.1 Descriptive Statistics Table 1 reports the summary statistics for the main variables for our sample firms in the pre-ibbea and post-ibbea periods, respectively. On average, 42% (45%) of the firm-years have option grants, captured by OptionD, in the pre-deregulation (postderegulation) period. The increase in option grants is positive, although not significant based on a univariate analysis (p=0.22). The distribution of the log of number of grants (LogNumOptions) also indicates an increase in option grants from 4.43 to Compared to prior research based on S&P 1500 firms (e.g., Hayes et al., 2012), our statistics suggest that small firms are less likely to use stock options. The distribution of other control variables is largely consistent with our expectation. We present the correlations between the variables used in the main analyses in Table 2. We find a positive correlation between 22

25 OptionD, LogNumOptions and Post, although they are not significant. The correlations among other variables are also consistent with our expectations in general. 5.2 Main Findings Table 3 presents the results of how firms change the use of stock options in management compensation after IBBEA. We find results consistent with H1. In columns 1 and 3, after controlling for other factors known to affect option grants and time, state and industry fixed effects, we find a positive and significant coefficient on Post (coefficient = and , both at the 5% level), suggesting that firms increase option grants in compensation packages after IBBEA to take advantage of banks enhanced geographic diversification and increased risk tolerance. In columns 2 and 4, we find that firms in states with fewer restrictions experience a greater increase in option grants (the coefficient on Post LessRestr is and , respectively, both at the 10% level) compared to states with more restrictions. 15 These findings are consistent with H2, further supporting the idea that firms executive compensation policy depends on the financial market developments and that IBBEA interstate branching reforms affect firm risk-taking incentives of companies that are apt to borrow from banks. Further, we provide two analyses based on banks diversification benefits to test whether the increased use of stock options in firm management compensation arises from increased diversification in bank loan portfolios. Columns 1 and 3 of Table 4 are based on Diversification1, in which we split the states according to how their economy commoves 15 We also re-run all the probit regressions using OLS estimation when the dependent variable is OptionD, and the inference is the same. 23

26 with the rest of the US. Consistent with our expectation, the increase in option grants is both statistically and economically more pronounced for firms in states where the economy is less correlated with the US overall economy, i.e., the states where banks enjoy more diversification benefits (the coefficients on Post Diversification1 are and , both significant at the 5% level). Columns 2 and 4 of Table 4 are based on Diversification2, in which we split the states according to how their economy commoves with the states where entering banks come from. The coefficients on Post Diversification2 are and in columns 2 and 4, respectively (p-value<0.10), supporting the notion that firms are more likely to increase the use of stock options when entering banks can better diversify their loan portfolios by expanding their operations into the state of interest. Overall, these findings together support H3, suggesting that banks enhanced risk tolerance, as a result of better geographic diversification after IBBEA, allows their clients borrowing firms to increase option grants in management compensation. 5.3 Supplemental Analyses Propensity of Borrowing Relationships with Local Banks To provide further evidence supporting the effect of debt financing on compensation, we explore whether the change in compensation after IBBEA depends on firms tendency to borrow from local banks. We expect that firms borrowing from local banks that are less diversified before IBBEA are better able to coordinate their compensation strategy to capture banks diversification benefits by borrowing from new 24

27 entering banks or local banks that expand operations to other states. 16 On the other hand, firms that had borrowed mostly from out-of-state banks are less affected by IBBEA because these banks are likely to be better diversified before IBBEA. We first examine whether the increase in the use of stock options varies with firms access to public debt financing in the pre-deregulation period. When firms have better access to public debt markets, they rely less on loan financing. In addition, based on Bharath et al. (2008), these firms may also have more transparent information environments that enable them to borrow from banks located farther away. Therefore, they are less likely to borrow from banks located in the headquarter state before IBBEA. In contrast, firms without access to public debt are more likely to borrow from local banks and therefore are likely to benefit more from bank diversification arising from IBBEA. Firms that issue public debt in the pre-deregulation period account for 25% of our sample. We expect that these firms experience a smaller change in compensation structures. Our second test is based on whether a firm relies on loans from local banks in the pre-deregulation period. A firm is categorized as a local borrower (i.e., PreLocBorrower =1) if its loans are entirely initiated by banks headquartered in the same state prior to the deregulation. We posit that the effect of IBBEA on management compensation should be stronger for firms that borrow exclusively from local banks prior to the deregulation (i.e., 19% of our sample), again because these firms can benefit more from the increased bank 16 This is not a necessary condition because competition in the loan market may affect the local banks operations. 25

28 diversification of entering banks or local banks compared to firms that had already borrowed from banks in other states. We also examine whether the increase in option grants varies with the size of the borrowing firm. Larger firms are more likely to rely on public debt and equity financing and are better able to borrow from banks that are distant geographically (Bharath et al., 2008; Agarwal and Hauswald, 2010). 17 In contrast, because smaller firms usually have more information asymmetry and moral hazard problems, they rely more on loan financing from local lenders that can monitor the borrower more closely and take advantage of the private information they acquire through relationship banking. As a result of IBBEA, smaller firms are expected to experience a larger change in compensation structures due to their capture of bank diversification benefits. In Table 5, we find results consistent with these expectations. That is, the effect of branching reforms on option grants in management compensation is less pronounced for firms with public debt issuance (columns 1 and 4) and larger size (columns 3 and 6). 18 We also find that firms that had entirely borrowed from local banks are more likely to experience an increase in option grants after IBBEA, compared to firms that had borrowed from banks in other states (columns 2 and 5). These results together are consistent with our expectation that firms prone to use local banks are more likely to take advantage of bank diversification and increased risk tolerance following IBBEA by increasing risk incentives to encourage management to take on risky projects. 17 Firms in the upper quartile of the market capitalization distribution are consider larger firm (i.e., LargerFirm=1 in Table 5; otherwise LargerFirm=0). 18 In column 6, the coefficient on Post LargerFirm is marginally significant (p-value=0.11, two tailed). 26