Authors: Hamid Mehran and Joshua Rosenberg

In this paper, we test the hypothesis that granting stock options to CEOs of banking firms motivates them to undertake riskier projects. We also investigate whether CEO stock option holdings reduce the bank’s incentive to borrow while inducing a buildup of regulatory capital. Using a sample of 549 bank-years for publicly traded banks from 1992 to 2002, we find evidence that equity volatility (total and residual) and asset volatility increase as CEO stock option holdings increase. In addition, it appears that granting CEO stock options motivates banks to reduce their use of debt as evidenced by lower levels of interest expense and federal funds borrowing. Furthermore, we show that banking firms that grant more options to their CEOs build up more capital in future years.