Level 3 Income and CEO Cash Compensation in the Financial Industry

Abstract

This article examines the role of fair value gains or losses related to Level 3 valuations in CEO cash compensation for U.S. financial firms. Our results show that Level 3 income is compensation-relevant. By separating Level 3 income into unrealized and realized Level 3 income, we find that CEO cash compensation is less sensitive to unrealized than realized Level 3 income, which indicates that compensation committees have a higher concern for the clawback problem associated with unrealized Level 3 income. A further analysis separating Level 3 income into positive and negative components shows that Level 3 losses are more compensation-relevant than Level 3 gains, thereby validating the argument that Level 3 losses are more credible than Level 3 gains. Overall, we find that Level 3 income is relevant for CEO cash compensation and that this phenomenon is mainly driven by its realized and loss components.