Executive compensation reform and banking performance

Abstract

In 2014, the Chinese government initiated the Compensation Reform Scheme for Central State-Owned Enterprises (SOEs) to address the issue of excessive executive pay. This reform was widely adopted by both central and local SOEs, spanning various sectors, including the financial industry. This thesis examines the impact of the compensation reform, with a particular focus on the banking sector. First, we establish that the reform resulted in a decrease in executive salaries within the targeted SOEs, with a more pronounced reduction in those SOEs that were previously unprofitable, poorly governed, or had CEOs below their retirement age prior to the reform. Second, the reform is found to lead to a reduction in bank profitability and a decrease in risk-taking behavior, as indicated by various metrics. This is consistent with the argument that the compensation reform, by limiting pay–performance sensitivity, constrains managerial incentives to enhance financial performance; yet by amplifying the unique role of banks in supporting financial stability and realigning managers’ incentives with broader social and political targets, the reform has induced state-owned bank managers to focus more on risk management. Third, we explore the mechanisms contributing to the decline in both bank profitability and risk-taking. We find that banks adjusted their leverage ratios downward post-reform but managed to sustain a lower non-performing loan ratio and a higher capital reserve ratio. Furthermore, an analysis of revenue breakdown reveals that banks reduced their commission-based sales activities, while relatively increasing interest revenue. Investment income decreased in certain subgroups, and banks lowered their exposure to derivatives in terms of assets and liabilities. These changes collectively signify a more risk-averse approach by banks, albeit at the expense of short-term financial profitability. Nevertheless, additional exploration shows that long-term performance of state-owned banks as measured by their charter value exhibits a weak increase following the reform, which suggest that the reform may have mitigated managerial myopia and induced managers to focus on long-term, value-enhancing activities. Heterogeneity analyses underscore that the effect of the reform is not linearly associated with the magnitude of salary reduction. This implies that reducing the salaries of SOE executives to a uniformly low level may not necessarily be an optimal solution. Last, we conduct a survey to gather insights into the experiences and opinions of employees in the banking sector regarding the reform. The survey results are generally consistent with our initial findings.