In our paper, Carrot or Stick? The Shift from Voluntary to Mandatory Disclosure of Risk Factors, we investigate public companies’ disclosure of risk factors that are meant to inform investors about risks and uncertainties. We compare risk factor disclosures under the voluntary, incentive-based disclosure regime provided by the safe harbor provision of the Private Securities Litigation Reform Act, adopted in 1995, and the SEC’s subsequent disclosure mandate, adopted in 2005.
Posts Tagged ‘Risk’
The Dodd-Frank Act was undoubtedly a thorough re-working of the regulatory paradigm for banks and other financial institutions. But no less resolute are the intentions of U.S. banking regulators to carry regulatory reform further, based in significant part on perceived “macroprudential” authority after Dodd-Frank. The new regulatory paradigm will increasingly leave behind bank regulation’s traditional moorings in the protection of federally insured deposits and safe and sound operation of banking organizations. Instead, “macroprudential” regulation will rest on the goals of protecting U.S. financial stability and reducing systemic risk—broad, malleable concepts that elude precise definition. It will seek to influence activities not just of banking organizations but also activities conducted by non-bank entities not traditionally subject to prudential regulation. And, according to an important speech given last week by Federal Reserve Governor Daniel K. Tarullo, the new regulatory paradigm embraces consideration of a potentially unprecedented expansion of the fiduciary duties of directors of banking institutions. This would give such directors very potent incentives to prioritize supervisory goals—including macroprudential objectives.
I am pleased to be here and to have the opportunity to speak about cyber-risks and the boardroom, a topic that is both timely and extremely important. Over just a relatively short period of time, cybersecurity has become a top concern of American companies, financial institutions, law enforcement, and many regulators. I suspect that not too long ago, we would have been hard-pressed to find many individuals who had even heard of cybersecurity, let alone known what it meant. Yet, in the past few years, there can be no doubt that the focus on this issue has dramatically increased.
In our forthcoming Journal of Finance paper, The Executive Turnover Risk Premium, we make the simple point that forced turnover risk explains an important part of the cross-sectional variation of compensation for the CEOs of public U.S. corporations. The empirical magnitude of the turnover risk premium—about 7% greater subjective compensation for a one percentage point increase in turnover risk—is in line with calibrated theoretical predictions.
To identify the turnover risk premium, we use sources of job risk that are arguably outside the CEO’s control such as changing industry conditions. This strategy relies on the idea that, in practice, firing occurs not only when the CEO reveals low general ability. Rather, a board may fire a CEO when industry conditions change in such a way that his skill set no longer matches the new industry requirements. It is this kind of exogenous risk exposure that should plausibly be compensated in CEO pay.
Worker participation in corporate governance varies across countries. While employees are rarely represented on corporate boards in most countries, Botero et al. (2004) state “workers, or unions, or both have a right to appoint members to the Board of Directors” in Austria, China, Czech Republic, Denmark, Egypt, Germany, Norway, Slovenia, and Sweden. Such board representation gives labor a means to influence corporate policies, which may affect productivity, risk sharing, and how the economic pie is shared between providers of capital and labor.
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.
Our observations on the Federal Reserve’s final rule:
1. Delayed effective date and higher threshold: Foreign Banking Organizations (FBOs) eked out several small victories in the final rule—in particular, the July 2015 compliance date has been pushed to July 2016 and smaller FBOs (i.e., those with under $50 billion in US non-branch assets) are no longer required to form an Intermediate Holding Company (IHC). The changes reflect the Federal Reserve’s attempt to respond to FBOs’ concerns, especially that smaller FBOs did not pose as much risk to US financial stability.
Standard principal-agent theory prescribes that managers should not be compensated on exogenous risks, such as general market movements. Rather, firms should index pay and use contracts that filter exogenous risks (e.g., Holmstrom 1979, 1982; Diamond and Verrecchia 1982). This prescription is intuitive and agrees with common sense: CEOs should receive exceptional pay only for exceptional performance, and “rational” compensation practice should not permit CEOs to obtain windfall profits in rising stock markets. However, observed compensation contracts are typically not indexed. Specifically, stock options almost never tie the strike price of the option to an index that reflects market performance or the performance of peers. Commentators often cite this glaring difference between theory and practice as evidence for the inefficiency of executive compensation practice and, more generally, as evidence for major deficiencies of corporate governance in U.S. firms (e.g., Rappaport and Nodine 1999; Bertrand and Mullainathan 2001; Bebchuk and Fried 2004). This paper therefore contributes to the discussion about which compensation practices reveal deficiencies in the pay-setting process.
The hedge fund industry has grown tremendously over the last two decades. While this growth is due to a number of factors, one explanation is that its performance-based compensation system creates incentives for managers to generate alpha. This incentive system, however, could also motivate some managers to manipulate net asset values or commit outright fraud. Due to the light regulatory environment hedge funds operate in and their secretive nature, monitoring managers is generally difficult for investors and regulators.
In response, recent research has attempted to infer malfeasance directly from the distribution of hedge fund returns. In particular, the finding of a pervasive discontinuity in the distribution of net returns around zero has been interpreted as evidence that hedge fund managers systematically manipulate the reporting of NAVs to minimize the frequency of losses. This literature, however, has not recognized that performance fees distort the pattern of net returns.
In our paper, Are Hedge Fund Managers Systematically Misreporting? Or Not?, forthcoming in the Journal of Financial Economics, we show that inferring misreporting based on a kink at zero can be misleading when ignoring incentive fees. Because these fees are applied asymmetrically to positive and negative returns, the distribution of net returns should display a natural discontinuity around zero. In other words, there is a mechanical explanation for the observed kink in the distribution of net returns. We demonstrate this effect by showing that funds without incentive fees have no discontinuity at zero until we add hypothetical incentive fees to their returns.
The SEC’s recent decision to take disclosure of political activities off the SEC’s agenda is a policy mistake, as it ignores the best research on the point, described below, and perpetuates a key loophole in the investor-relevant disclosure rules, allowing large companies to omit material information about the politically inflected risks they run with other people’s money. It is also a political mistake, as it repudiates the 600,000+ investors who have written to the SEC personally to ask it to adopt a rule requiring such disclosure, and will let entrenched business interests focus their lobbying solely on watering down regulation mandated under the Dodd-Frank Act and the 2012 securities law statute, rather than having also to work to influence a disclosure regime.