Posts Tagged ‘Risk-taking’

Excess Risk Taking and Competition for Managerial Talent

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday March 31, 2014 at 9:07 am
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Editor’s Note: The following post comes to us from Viral Acharya, Professor of Finance at NYU; Marco Pagano, Professor of Economic Policy at the University of Naples Federico II; and Paolo Volpin, Professor of Finance, Cass Business School.

Excessive risk-taking by financial institutions and overly generous executive pay are widely regarded as key factors in the 2007-09 crisis. In particular, it has become commonplace to blame banks and securities companies for compensation packages that reward managers (and more generally, other risk-takers such as traders and salesmen) generously for making investments with high returns in the short run but large risks that emerge only in the long run. As governments have been forced to rescue failing financial institutions, politicians and the media have stressed the need to cut executive pay packages and rein in incentives based on options and bonuses, making them more dependent on long-term performance and in extreme cases eliminating them outright. It is natural to ask whether this is the right policy response to the problem. It is crucial to ask what is the root of the problem—that is, precisely which market failure produced excessive risk-taking.

…continue reading: Excess Risk Taking and Competition for Managerial Talent

Risk Choice under High-Water Marks

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Thursday March 20, 2014 at 9:03 am
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Editor’s Note: The following post comes to us from Itamar Drechsler of the Department of Finance at New York University Stern School of Business.

High-water mark (HWM) contracts are the predominant compensation structure for managers in the hedge fund industry. In the paper, Risk Choice under High-Water Marks, forthcoming in the Review of Financial Studies, I seek to understand the optimal dynamic risk-taking strategy of a hedge fund manager who is compensated under such a contract. This is both an interesting portfolio-choice question, and one with potentially important ramifications for the willingness of hedge funds to bear risk in their role as arbitrageurs and liquidity providers, especially in times of crises. High-water mark mechanisms are also implicit in other types of compensation structures, so insights from this question extend beyond hedge funds. An example is a corporate manager who is paid performance bonuses based on record earnings or stock price and whose choice of projects influences the firm’s level of risk.

…continue reading: Risk Choice under High-Water Marks

Understanding the Failures of Market Discipline

Posted by June Rhee, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Tuesday March 18, 2014 at 9:28 am
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Editor’s Note: The following post comes to us from David Min of University of California, Irvine School of Law.

Last week, James Kwak (UConn law professor, co-author of 13 Bankers and White House Burning, and blogger at the Baseline Scenario) provided a nice writeup of some of the key issues I identify in my paper, Understanding the Failures of Market Discipline, recently posted to SSRN. But I wanted to take a few words to provide a slightly more detailed explanation of my work.

“Market discipline”—the notion that short-term creditors (such as bank depositors) can efficiently identify and rein in bank risk—has been a central pillar of banking regulation since the 1980s. Obviously, market discipline did not prevent the buildup of bank risk that caused the recent financial crisis, but the general consensus has been that this failure was due to structural impediments to the effective operation of market discipline—such as misaligned incentives, a lack of transparency, or moral hazard caused by implicit guarantees—rather than any problems with the concept itself. As a result, a major point of emphasis in financial regulatory reform efforts has been to improve and strengthen market discipline.

…continue reading: Understanding the Failures of Market Discipline

Financing as a Supply Chain

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Thursday February 27, 2014 at 9:20 am
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Editor’s Note: The following post comes to us from Will Gornall and Ilya Strebulaev, both of the Finance Area at Stanford University.

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.

…continue reading: Financing as a Supply Chain

CEO Job Security and Risk-Taking

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday February 26, 2014 at 9:04 am
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Editor’s Note: The following post comes to us from Peter Cziraki of the Department of Economics at the University of Toronto and Moqi Xu of the Department of Finance at the London School of Economics.

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.

…continue reading: CEO Job Security and Risk-Taking

Managerial Risk Taking Incentives and Corporate Pension Policy

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday January 15, 2014 at 9:00 am
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Editor’s Note: The following post comes to us from Divya Anantharaman of the Department of Accounting and Information Systems at Rutgers Business School and Yong Gyu Lee of the School of Business at Sungkyunkwan University.

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.

…continue reading: Managerial Risk Taking Incentives and Corporate Pension Policy

Corporate Governance, Incentives, and Tax Avoidance

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Thursday June 20, 2013 at 9:08 am
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Editor’s Note: The following post comes to us from Christopher Armstrong and Jennifer Blouin, both of the Department of Accounting at the University of Pennsylvania; Alan Jagolinzer of the Division of Accounting at the University of Colorado; and David Larcker, Professor of Accounting at Stanford University.

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.

…continue reading: Corporate Governance, Incentives, and Tax Avoidance

Downside Risk and the Design of CEO Incentives

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday June 10, 2013 at 8:56 am
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Editor’s Note: The following post comes to us from David De Angelis, Gustavo Grullon, and Sebastien Michenaud, all of the Finance Area at Rice University.

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.

…continue reading: Downside Risk and the Design of CEO Incentives

Incentive Schemes for Nominees of Activist Investors

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday June 5, 2013 at 9:34 am
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Editor’s Note: The following post comes to us from Neil Whoriskey, partner focusing on mergers and acquisitions at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb memorandum by Mr. Whoriskey, titled “Golden Leashes, Honest Brokers, Risk Tolerances and Market Imperfections: Incentive Schemes for Nominees of Activist Investors.”

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:

…continue reading: Incentive Schemes for Nominees of Activist Investors

The Relation between Equity Incentives and Misreporting

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday May 20, 2013 at 9:38 am
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Editor’s Note: The following post comes to us from Christopher Armstrong and Daniel Taylor, both of the Department of Accounting at the University of Pennsylvania; David Larcker, Professor of Accounting at Stanford University; and Gaizka Ormazabal of the Department of Accounting and Control at the University of Navarra, IESE Business School.

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.

…continue reading: The Relation between Equity Incentives and Misreporting

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