Compensations, overconfidence and use of loan terms

Jan VOON*, Yiu Chung MA

*Corresponding author for this work

Research output: Journal PublicationsJournal Article (refereed)peer-review

Abstract

Purpose
This paper contributes to the literature as follows. First, it examines if option and stock compensations raise creditor's risk, and which one is more important than the other. Second, it explores if CEO's compensation interacts with CEO overconfidence to raise creditor's risk. Third, it investigates how banks use different loan terms to alleviate their credit risk.

Design/methodology/approach
This study used advanced regression analysis and use of generalized methods of moment methodology.

Findings
The results show that option compensation is more important than stock compensation in raising credit risk; option compensation interacts with CEO overconfidence, giving rise to a much higher credit risk; and covenant usage is more important than other loan contract terms in mitigating credit risk given that covenant use could not be substituted away by using other loan contract terms such as increasing interest rate, reducing principal or shortening loan duration. This paper has practical implications for credit markets.

Research limitations/implications
The main implication is that hand-collect data are available up to 2010.

Practical implications
It informs creditors the potential sources of loan risk emanating from option rather than stock incentives; it informs creditors that option incentive interacts with CEO overconfidence rendering the credit risk bigger than expected, and it informs creditors the importance of using covenants vis-à-vis other loan contract terms for mitigating compensation and overconfidence risk.

Social implications
Banks are alerted to the risk due to the interaction between overconfidence and compensations, implying that overconfident managers remunerated with options compensations are more risky than overconfident managers who are not remunerated as such.

Originality/value
This paper is original: (1) The authors show that option compensation is more risky than stock compensation from viewpoint of creditors. This has not been assessed. (2) Interaction between managerial compensation and managerial overconfidence has not been assessed before. (3) Use of different loan contract terms to alleviate risk from overconfident managers (who are prone to over investment but who are innovative according to the literature) has not been evaluated.
Original languageEnglish
Number of pages26
JournalInternational Journal of Managerial Finance
Early online date15 Sept 2023
DOIs
Publication statusE-pub ahead of print - 15 Sept 2023

Bibliographical note

Publisher Copyright:
© 2023, Emerald Publishing Limited.

Keywords

  • Managerial overconfidence
  • Interaction effect
  • Credit market
  • Compensations
  • Loan contract terms

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