In our recent NBER working paper, Financing as a Supply Chain: The Capital Structure of Banks and Borrowers, we propose a novel framework to model joint debt decisions of banks and borrowers. Our framework combines the models used by bank regulators with the models used to explain capital structure in corporate finance. This structure can be used to explore the quantitative impact of government interventions such as deposit insurance, bailouts, and capital regulation.
Posts Tagged ‘Risk-taking’
In our paper, CEO Job Security and Risk-Taking, which was recently made publicly available on SSRN, we use the length of employment contracts to estimate CEO turnover probability and its effects on risk-taking. Protection against dismissal should encourage CEOs to pursue riskier projects. Indeed, we show that firms with lower CEO turnover probability exhibit higher return volatility, especially idiosyncratic risk. An increase in turnover probability of one standard deviation is associated with a volatility decline of 17 basis points. This reduction in risk is driven largely by a decrease in investment and is not associated with changes in compensation incentives or leverage.
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.
There has been a recent surge in research that seeks to understand the sources of variation in tax avoidance (e.g., Shevlin and Shackelford, 2001; Shevlin, 2007; Hanlon and Heitzman, 2010). The benefits of tax avoidance can be economically large (e.g., Scholes et al., 2009) and tax avoidance can be a relatively inexpensive source of financing (e.g., Armstrong et al., 2012). However, aggressive tax avoidance may be accompanied by substantial observable (e.g., fines and legal fees) and unobservable (e.g., excess risk and loss of corporate reputation) costs. Although understanding the factors that influence managers’ tax avoidance decisions is an important research question that has broad public policy implications, relatively little is known about why some firms appear to be more tax aggressive than others.
In our paper, Corporate Governance, Incentives, and Tax Avoidance, which was recently made publicly available on SSRN, we examine whether variation in firms’ corporate governance mechanisms explains differences in their level of tax avoidance. We view tax avoidance as one of many investment opportunities that is available to managers. Similar to other investment decisions, managers have personal incentives to engage in a certain amount of tax avoidance that may not be in the best interest of shareholders, thereby giving rise to an agency problem. From the perspective of the firm’s shareholders, unresolved agency problems with respect to tax avoidance can manifest as either “too little” or “too much” tax avoidance. As with other agency problems, certain corporate governance mechanisms can mitigate agency problems with respect to tax avoidance.
In our paper, Downside Risk and the Design of CEO Incentives: Evidence from a Natural Experiment, which was recently made publicly available on SSRN, we investigate how downside risk influences the design of CEOs’ incentives. Studying the relationship between firm risk and managerial incentives is a difficult task due to the endogenous nature of the relationship: empiricists cannot easily disentangle the effect of compensation on risk from the effect of risk on compensation (Prendergast, 2002). We address the identification challenge by exploiting a randomized natural experiment that exogenously increased downside equity risk through the relaxation of short-selling constraints. Because the removal of short-selling constraints may cause an increase – or the fear of an increase – in bear raids and market manipulation by short-sellers (Goldstein and Guembel (2008)), this increase in downside risk potentially exposes managers to losses that are beyond their control. In this scenario, CEOs may sub-optimally reduce the risk of their firms to protect their personal wealth and firm-specific human capital (Amihud and Lev (1981), May (1995)). Consistent with this view, firms and their CEOs display an acute aversion to short-sellers, and go to great lengths to fight them and reduce their influence on stock prices (Lamont (2012)). As a result, firms that maximize shareholder value should respond to an exogenous increase in short selling activity by increasing their CEOs’ risk-taking incentives to avoid sub-optimal risk reduction policies, and/or by immunizing their CEOs against the downside risk that lies outside of their control and does not reflect their performance.
Golden leashes – compensation arrangements between activists and their nominees to target boards – have emerged as the latest advance (or atrocity, depending on your point of view) in the long running battle between activists and defenders of the long-term investor faith. Just exactly what are we worried about?
With average holding periods for U.S. equity investors having shriveled from five years in the 1980s to nine months or less today, the defenders of “long-termism” would seem to have lost the war, though perhaps not the argument. After all, if the average shareholder is only sticking around for nine months, and if directors owe their duties to their shareholders (average or otherwise), then at best a director on average will have nine months to maximize the value of those shares. Starting now. Or maybe starting nine months ago.
But this assumes that the directors of any particular company have a real idea of just how long their particular set of “average” shareholders will stick around, and it also assumes that the directors owe duties primarily to their average shareholders, and not to their Warren Buffett investors (on one hand) or their high speed traders (on the other). So, in the absence of any real information about how long any then-current set of shareholders will invest for on average, and in the absence of any rational analytical framework to decide which subset(s) of shareholders they should be acting for, what is a director to do?
Here is what I think directors do, in one form or fashion or another:
A large body of prior literature examines the relation between managerial equity incentives and financial misreporting but reports mixed results. This literature argues that a manager whose wealth is more sensitive to changes in stock price has a greater incentive to misreport. However, if managers are risk-averse and misreporting increases both equity values and equity risk, managers face a risk/return tradeoff when making a misreporting decision. In this case, the sensitivity of the manager’s wealth to changes in stock price, or portfolio delta, will have two countervailing incentive effects: a positive “reward effect” and a negative “risk effect.” In contrast, the sensitivity of the manager’s equity portfolio to changes in risk, or portfolio vega, will have an unambiguously positive incentive effect. Accordingly, when managers are risk-averse, it is important to jointly consider both portfolio delta and portfolio vega when assessing the relation between equity incentives and misreporting.
In our paper, The Relation Between Equity Incentives and Misreporting: The Role of Risk-Taking Incentives, forthcoming in the Journal of Financial Economics, we show that jointly considering both portfolio delta and portfolio vega substantially alters inferences reported in the literature. Specifically, we find inferences in studies reporting either a positive relation or no relation between portfolio delta and misreporting are not robust to controlling for vega.
In my paper Inside Debt and Mergers and Acquisitions, forthcoming in the Journal of Financial and Quantitative Analysis, I examine the link between CEO inside debt holdings and corporate risk-taking in M&A activities and its implications for bondholder, shareholder, and firm value. M&As are among the largest and most readily observable forms of corporate investment, which tend to intensify the inherent conflict of interests among shareholders, bondholders, and managers. Manager’s pension benefits and deferred compensation are debt-like compensation since they represent fixed obligations by the company to make future payments to corporate insiders/managers (hence, these are usually referred to as “inside debt”). Inside debt is expected to align manager interests with those of external debtholders and alleviate managers’ risk-taking incentive since inside debt is typically unsecured and unfunded, and if the firms go bankrupt, managers have equal claims as those of other unsecured creditors. Therefore, M&As provide a unique ground for testing the potential effects of debt-like compensation on corporate investment and financing strategies and the implications of the stakeholders’ interests.
How competition affects firm performance is a central question of economics. As in other sectors, competitive pressure in the banking sector can influence the efficiency of bank operations, the quality of financial products, and the extent of innovation. However, unique to the financial sector is the potential link between competition and financial stability. Does bank competition promote financial stability or undermine it by creating incentives for excessive risk-taking? Further, assessing the influence of bank competition on risk-taking behavior is of critical importance to financial analysts, credit rating agencies and investors who seek to forecast banks’ future prospects. This task is perhaps more difficult in banking relative to other industries, given the wide-spread perception that banks are unusually opaque.
In our paper, Perceived Bank Competition: Operational Decision-Making and Bank Stability, which was recently made publicly available on SSRN, we utilize a bank-specific measure that extracts a bank’s perception of its competitive environment from a textual analysis of its 10-K filing. The premise is that managers’ perceptions of the competitive environment influence their operating and risk-taking decisions. We show that this measure is related to future operating performance and bank decision-making in ways that suggest it captures real competitive forces exerting pressure on banks.
The recent financial crisis and the ensuing economic slowdown have heightened the importance of better understanding the interconnectedness between the industrial and banking sectors. While several recent studies undertake this endeavor, the transmission mechanism in these studies is almost always from the banking sector to the industrial sector. In contrast, in our paper, The Effect of Industrial-Sector Transparency on Bank Risk-taking and Banking System Fragility, which was recently made publicly available on SSRN, my co-author (Sudarshan Jayaraman) and I provide evidence of the chain of causality working in the reverse direction, i.e., from the industrial sector to the banking sector. In particular, we document the important role that industrial-sector transparency plays in the efficient functioning of the banking sector. We argue that greater transparency in the industrial sector facilitates firms’ access to financing from capital markets and thus diminishes their reliance on banks. As a result, we expect banks to face increased competition in their product markets and to offset their lost rents by: (i) taking on more risk, (ii) reducing their cost structures, and (iii) increasing the intensity of intermediation.