Staff Reports
The Effect of Employee Stock Options on Bank Investment Choice, Borrowing, and Capital
October 2007 Number 305
Revised June 2008
JEL classification: G21, G28, G32, J33, M41

Authors: Hamid Mehran and Joshua Rosenberg

In this paper, we assess the effects of CEO stock options on three key corporate policies for banks: investment choice, amount of borrowing, and level of capital. Using a sample of 549 bank-years for publicly traded banks from 1992 to 2002, we find that stock option grants lead CEOs to undertake riskier investments. In particular, higher levels of option grants are associated with higher levels of equity and asset volatility. Consistent with the role of options as a nondebt tax shield, we also show that option grants reduce the banks’ incentive to borrow as evidenced by lower levels of interest expense and federal funds borrowing. Furthermore, we demonstrate that increases in CEO and employee stock option grants result in increased bank capital levels, perhaps because option grants create a contingent liability for the firm that needs to be funded in advance.

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