In prior articles (see, e.g., Regulating Shadows: Financial Regulation and Responsibility Failure, 70 Wash. & Lee L. Rev. 1781 (2013)), I have argued that shadow banking is so radically transforming finance that regulatory scholars need to rethink certain of their basic assumptions. In a forthcoming new article, The Governance Structure of Shadow Banking: Rethinking Assumptions About Limited Liability, I argue that the governance structure of shadow banking should be redesigned to make certain investors financially responsible, by reason of their ownership interests, for their firm’s liabilities beyond the capital they have invested. This argument challenges the longstanding assumption of the optimality of limited liability.
Posts Tagged ‘Moral hazard’
In our paper, Managerial Risk Taking Incentives and Corporate Pension Policy, forthcoming in the Journal of Financial Economics, we examine whether the compensation incentives of top management affect the extent of risk shifting versus risk management behavior in pension plans.
The employee beneficiaries of a firm’s defined benefit pension plan hold claims on the firm similar to those held by the firm’s debtholders. Beneficiaries are entitled to receive a fixed stream of cash flows starting at retirement. The firm sponsoring the plan is required to set aside assets in a trust to fund these obligations, but if the sponsor goes bankrupt with insufficient assets to fund pension obligations, beneficiaries are bound to accept whatever reduced payouts can be made with the assets secured for the plan.
Most of the empirical work on executive compensation investigates the role of contemporaneous performance measures in setting cash compensation, ignoring the relevance of past performance measures and the structure of cash compensation. In our paper, The Relation between CEO Compensation and Past Performance, forthcoming in The Accounting Review, we focus on the relation between cash compensation components (salary and bonus) and past performance measures as signals of a CEO’s ability.
We first develop a simple two-period principal-agent model with moral hazard and adverse selection. Our model suggests that salary is adjusted to meet the reservation utility and information rent, and is positively correlated over time to reflect ability. Bonus serves to address moral hazard and adverse selection problems by separating agents into contracts with different levels of risk. Agents are screened and receive different bonus arrangements according to their types. The higher an agent’s type, the more sensitive his bonus is to contemporaneous performance. A higher ability agent receives a larger portion of his compensation in the form of bonus and less as salary. For a given agent, salary increases with his past performance and higher current salary predicts higher future performance. Current bonus, however, is negatively correlated with both past and future performance.
Formulation of optimal regulation of asset-backed securities (ABS) markets has been hindered by the inability to identify specific market failures as well as the absence of well-defined social welfare objectives. In our paper, Skin in the Game and Moral Hazard, which was recently presented at Harvard University, we develop a tractable framework for analyzing social welfare in both regulated and unregulated ABS markets, accounting for moral hazard at the origination stage, private information at the distribution stage, and asymmetric information across ABS investors. We show originators operating in unregulated markets fail to internalize the costs they impose on investors if they utilize a common ABS structure (e.g. zero retentions) rather than credibly signaling positive information to the market via higher retentions. Further, originator effort incentives are reduced since those developing high value assets must either signal via high retentions or otherwise face underpricing of their securities. Mandated retentions have the potential to raise welfare by increasing originator effort incentives in an efficient way, accounting for investor-level spillovers.
The first important policy implication to emerge from the model is that regulators must choose between a “one-size scheme” under which all originators are forced to hold the same retention size (e.g. 5%) or a “menu scheme” under which originators must choose amongst multiple retention sizes (e.g. 4% or 8%). Both schemes can restore effort incentives. However, the menu scheme carries the added social benefit of allowing originators to signal positive information to investors via the choice of a larger retention. Signaling promotes efficient sharing of risks by mitigating the adverse selection problem confronting uninformed ABS investors. The weakness of the menu scheme is that it generally results in higher average retentions, resulting in lower originator fundraising.
The governance structure of a firm can influence any number of its policies and actions, sometimes to the benefit and sometimes to the detriment of shareholders. Among the many studies of these relationships, numerous ones investigate the link between firm governance and corporate investment; however, the findings are inconclusive. Some studies report results suggesting poor governance associates with excessive investment (over-investment or empire-building), while others suggest the opposite (poorly governed managers may prefer the “quiet life”).
In our paper, The Influence of Governance on Investment: Evidence from a Hazard Model, forthcoming in the Journal of Financial Economics, we revisit the question of how governance affects corporate investment behavior in an attempt to reconcile these conflicting findings. Unlike prior studies we use a hazard framework, wherein we study how governance influences the time between large investment expenditures. This empirical approach helps alleviate some of the concerns with the methods of prior studies and also provides an unexplored perspective. In this framework, we find that governance does influence the time between major investments (investment spikes). Poor governance associates with shorter periods between spikes than that for firms with stronger governance. We further show that this relation is due to poorly governed firms over-investing, rather than stronger governance firms under-investing.
In the paper, Safer Ratios, Riskier Portfolios: Banks’ Response to Government Aid, which was recently made publicly available on SSRN, we investigate the effect of TARP on bank risk taking. One of the key features of the past decade has been an increased role of government regulation, which culminated in the bailout of over 700 firms under the Emergency Economic Stabilization Act (EESA) of 2008. At the forefront of an ongoing regulatory debate is the potential effect of the bailout on the risk-taking behavior of financial institutions, since imprudent risk-taking is often blamed for leading to the crisis in the first place. On the one hand, recent regulatory reforms, including the EESA, the Dodd-Frank Act of 2010, and Basel III, were tasked with promoting financial stability and preventing excessive risk-taking by financial institutions. On the other hand, the bailout sent a signal of implicit protection of certain financial institutions, which could encourage risk-taking as a response to a perceived safety net for institutions that encounter financial distress.
We study three channels of bank operations – retail lending, corporate lending, and financial investments. We use hand-collected data on bank applications for government capital to control for the selection of fund recipients and investigate the effect of both application approvals and denials. To distinguish banks’ risk taking behavior from changes in economic conditions, we also control for the volume and quality of credit demand based on micro-level data on home mortgages and corporate loans.
Did mortgage securitization cause the mortgage crisis? One popular story goes like this: Banks that originated mortgage loans and then sold them to securitizers didn’t care whether the loans would be repaid. After all, since they sold the loans, they weren’t on the hook for the defaults. Without any “skin in the game” those banks felt free to make worse and worse loans until… kaboom! The story is an appealing one, and since the beginning of the crisis it has gained popularity among academics, journalists, and policymakers. It has even influenced financial reform. The only problem? The story might be wrong.
In this post we report on the latest round in an ongoing academic debate over this issue. We recently released two papers, available here and here, in which we argue that the evidence against securitization that many have found most damning has in fact been misinterpreted. Rather than being a settled issue, we believe securitization’s role in the crisis remains an open and pressing question.
In the aftermath of the recent financial crisis, bank remuneration remains a critically sensitive issue – for shareholders, creditors, regulators, governments and the general public. This is particularly the case for those systemically important financial institutions that received government bailouts. While many of these institutions are beginning to recover, the negative effects of increased debt taken on at the public sector level to protect the financial system have resulted in serious and lingering economic problems in many countries, including the UK and the US. Indeed, the impact of public sector balance sheets absorbing losses of the banking sector has had the after-effect of contributing to sovereign debt crises in several smaller European jurisdictions — which continue to plague investors, taxpayers and the wider economy.
In the paper, Leverage, Moral Hazard, and Liquidity, forthcoming in the Journal of Finance (February 2011), the authors argue that the buildup of leverage in the financial sector in good economic times helps explain why adverse asset shocks in such times are associated with a severe drying-up of liquidity and deep discounts in asset prices. We illustrate that while the incidence of financial crises is lower when expectations of fundamentals are good, their severity can in fact be greater in such times due to greater system-wide leverage.
The core foundation of their theoretical model lies in the idea that when adverse asset shocks wipe out capital base of financial intermediaries, their short-term debt cannot be rolled over due to attendant agency problems, in particular, due to the problem that intermediaries may gamble excessively if leverage is not reduced. They tie this problem of rollover risk with the following facts: (i) the prominence of short-term rollover debt in the capital structure of financial firms, and (ii) the low cost of rollover debt in good economic times, which leads to the entry of highly leveraged firms in the financial sector. All of these factors played an important role in the financial crisis of 2007 to 2009 and the period preceding it.
Perhaps no academic paper has done more to convince scholars and policymakers that mortgage securitization led to lax screening by lenders and fueled the subprime crisis than did the recent paper by Keys, Mukherjee, Seru, and Vig (forthcoming in the Quarterly Journal of Economics, 2010) (hereafter, KMSV, who published a post in June on the Forum, which is available here). In an innovative paper, they argue that mortgage purchasers follow a “rule of thumb” in deciding which loans to purchase: they are, for exogenous reasons, much more willing to buy mortgage loans given to borrowers with credit scores above 620 than those given to borrowers with credit scores below 620. In a dataset containing only securitized loans, they find that loans made to borrowers just above 620 (where securitization is easy) default at a higher rate than those just below and argue that this is strong evidence that securitization really did result in lax screening by lenders.
In a new paper, Securitization and Moral Hazard: Evidence from Lender Cutoff Rules, which we recently presented at the Harvard Business School / Harvard Economics Finance Lunch Seminar, we reexamine the credit score cutoff rule evidence with a better dataset and through a theoretical lens that assumes rational equilibrium behavior and reach a very different conclusion.