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| Effects of China's Compensation Deferral Policy on Bank Profit Efficiency: Evidence from the Bank Level |
| WANG Yanyan, WANG Chenglong, YU Lisheng, LAN Yiyang
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School of Management, Xiamen University;
School of Accounting, Zhongnan University of Economics and Law |
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Abstract China's compensation deferral policy is a debt incentive reform designed to help banks avert systemic risks. It aims to reduce the probability of bank risk-taking behaviors caused by the mismatch of incentives and risks. The reform plays important roles in averting and defusing major risks and promoting a virtuous cycle between economy and finance. The literature thoroughly discusses how compensation deferral affects risks, but there is less discussion on how compensation deferral affects bank profit efficiency.
Prior research does not consistently conclude whether the relationship between bank risks and bank profit efficiency is based on a synergy effect or a crowding-out effect. It is difficult to assess the impacts of China's debt incentive reform on bank profit efficiency throngh the relationship between compensation deferral and bank risk-taking. More importantly, there remains a lack of evidence regarding how risk prevention policy affects bank profit efficiency. The bank behavior changes when responding to the policy, their behaviors change, resulting in unexpected economic consequences. From the perspective of the incentive effect, the pay level of a bank's management is directly linked to the bank's profit efficiency. Hence, the implementation of compensation deferral will increase the uncertainty of executive interests, and thus weaken management's motivation to improve profit efficiency. However, because of career concerns, bank managers need to prevent declines in profit efficiency after reforms are imposed, otherwise their careers could be negatively affected. Furthermore, if management cannot identify underlying risks, it is usually difficult for a bank to effectively increase income or save costs. Further study is needed on whether and how compensation deferral affects a bank's profit efficiency.
Using a 2007 to 2018 sample of Chinese commercial banks, this paper uses the difference-in-differences method with staggered adoption to study the effects of compensation deferral on bank efficiency and the mechanisms causing the effects. The results show that the implementation of compensation deferral internalizes management behavior and reduces a bank's risk-taking activities. Compensation deferral may result in the reduction of a bank's profitability by decreasing revenue rather than increasing costs, and thereby causing profit efficiency to decline. However, the parallel trend test shows that the effect on profit efficiency is reversed at the fifth year after compensation deferral is implemented. Hence, the policy makes management pay more attention to the persistence of long-term performance, which helps reduce long-term performance volatility. Further analysis finds that the negative relationship between compensation deferral and bank efficiency mainly exists in joint stock banks(JSBS). This paper also finds that the implementation of equity incentives and the acceptance of moderate ARIX holdings can help weaken the negative relationships between bank efficiency and compensation deferral. Our paper shows that although compensation deferral negatively affects short-term bank performance, it also causes management to pay more attention to the stability and persistence of long-term bank performance. From the profitability perspective, our findings provide theoretical evidence for the effects of China's deferral compensation policy on the prevention of risks and stabilization of growth.
This paper makes several contributions. First, it explores the impact of compensation deferral reform on profit efficiency from a bank's micro-perspective. Previous research mostly examines whether compensation deferral can effectively avert and defuse risks from a regulatory perspective. This paper supplements the previous evidence on how the compensation deferral reform affects profit efficiency and stability from a bank's micro-perspective. The paper also analyzes the mechanisms by which compensation deferral affects bank profit efficiency from the cost and benefit dimensions, thereby providing a more comprehensive and in-depth understanding of how compensation deferral affects bank behavior. Second, this paper uses an exogenous shock to mitigate the endogeneity issue. It examines how changes in a bank's real behavior in response to the compensation deferral reform affect the bank's profit efficiency. Most studies discuss the relationship between risk and efficiency from the perspective of bank capital. However, there is strong endogeneity between risk prevention and bank profit efficiency. This paper uses the exogenous shock caused by the introduction of compensation deferral to control the impact of risks and analyze the mechanisms that directly affect a bank's profit efficiency. Finally, this paper finds that the implementation of equity incentives can alleviate the decline in profit efficiency caused by compensation deferral. Given that the compensation deferral reform plays a positive role in averting risks and stabilizing growth, our conclusions provide a reference on how to avert risks while limiting the consequential costs to profit efficiency.
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Published: 02 November 2021
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