This paper tests the hypothesis that banks with more risky loans and higher interest-rate risk exposure would select loan and deposit rates to achieve higher net interest margins. Call Report data for different size classes of banks for 1989–1993 show that the net interest margins of commercial banks reflect both default and interest-rate risk premia. The net interest margins of money-center banks are affected by default risk, but not by interest rate risk, which is consistent with their greater concentration in short-term assets and off-balance sheet (OBS) hedging instruments. By contrast, (super-) regional banking firms are sensitive to interest-rate risk but not to default risk. The data show that OBS activities promote a more diversified, margins-generating asset base than deposit- or equity-financing, and that cross-sectional differences in interest-rate risk and liquidity risk are related to differences in OBS exposure.

We examine the relationship between top management compensation and the structure of the board of directors for a sample of commercial banks. We find that boards with more reputable outside directors compensate managers more heavily with long-term incentives (stock and stock options) than with cash (salary and bonus). We also find a significant positive correlation between the future performance of our sample banks and the proportion of their managers’ compensation in the form of long-term incentives. Taken together, these results suggest that boards with highly reputed outside directors are more effective in providing managers with the appropriate incentives and thus ensuring better future firm performance. Another indication of the effectiveness of these boards is our finding that they compensate managers more heavily with long-term incentives (instead of cash) when these managers are more entrenched. We also find very little evidence of mutually beneficial back-scratching or collusion between outside directors and senior managers when setting management compensation. But boards with long-serving outside directors are less effective in creating appropriate management incentives.