CEO Contract Design Regulation and Risk-Taking

Since 2009, the European Commission (EC) requires firms to incorporate an array of new elements into CEO compensation contracts, such as bonus caps, claw back provisions, bonus deferral, performance-vesting, and minimum shareholding guidelines. This paper examines whether CEO contract design in line with the EC principles reduces risk-taking and its economic consequences. Using hand-collected contract design data of 763 firm-years from European listed non-financial firms, we construct an index that reflects a firm's contract fit with the EC principles. Complemented by hand-collected data of national regulatory changes consistent to the EC principles, we employ the regime shift as quasi-experiment. We find that CEOs rewarded under contracts more in line with the principles choose lower risk profiles with respect to their country peers by divergent reductions of idiosyncratic and systematic risk-taking. Moreover, intensity of change of the regulatory environment negatively affects systematic risk-taking. Furthermore, we find CEOs compensated under contracts more adhering to the principles lead to increased subsequent risk-adjusted performance.