Title: EXECUTIVE%20COMPENSATION,%20RISK%20TAKING%20and%20THE%20STATE%20OF%20THE%20ECONOMY
1EXECUTIVE COMPENSATION, RISK TAKINGandTHE STATE
OF THE ECONOMY
- Alon Raviv (Bar Ilan University)
- Elif Sisli-Ciamarra (Brandeis University)
- Ackerman Conference on Corporate Governance
- Dec 2012
2The Financial Crisis and the Reforms in the
Executive Compensation Practices
- Executive compensation practices in the financial
industry have been identified as one of the
leading contributors to the financial crisis.
3The Financial Crisis and the Reforms in the
Executive Compensation Practices
- Financial Stability Forum (April 2, 2009)
- Perverse incentives amplified the excessive
risk-taking that severely threatened the global
financial system - G20, Pittsburg Summit (September 24-25, 2009)
- "Excessive compensation in the financial sector
has both reflected and encouraged excessive
risk-taking - Guidance on Sound Incentive Compensation Policies
(June 21, 2010) - Banking organizations too often rewarded
employees for increasing the organizations
revenue or short-term profit without adequate
recognition of the risks the employees
activities posed to the organization
4Regulating Executive Compensation
- Section 956 of the Dodd-Frank Wall Street Reform
and Consumer Protection Act generally, require
that rules be written regarding executive
compensation based on arrangements which will not
encourage excessive risk taking. - Implementation Issues
- How do we measure the risk taking incentive
implied by a specific compensation? - Is the risk taking motivation is affected by
other factors?
5Regulating Executive Compensation
- Guidance on Sound Incentive Compensation Policies
(June 21, 2010) takes into account only the
effect of equity based compensation. - However, there are additional components of
executive compensation that are also sensitive to
firm risk and would affect managerial risk taking
motivation - Loss of the executive due to firm-specific
financial distress - e.g., loss of pension benefits, reputation costs,
cost of transition to a new job. - Loss of the executive due to systemic crisis
- additional loss in the value of an executives
expected wealth from employment if the financial
institution becomes insolvent during a systemic
crisis.
6In order to design incentive compensation schemes
that limit excessive risk-taking practices, we
need to know
- How to design an incentive compensation structure
that would motivate the executive to achieve the
optimal level of risk? - Main subject of this study.
- Novel in this paper
- We introduce the idea that an executives
motivation to take risk may differ under
different state of the economy - Loss of the executive due to systemic crisis
- What is the optimal level of asset risk for a
banking organization? - Not a subject of this study.
- We will take the optimal level of asset risk as
given.
7Main Idea
- Main goal of the paper
- to integrate the state of the economy in the
analysis of executive compensation and risk
taking, - Main contributions to the existing literature
- to illustrate that a given compensation package
may lead to different levels of asset risk under
different economic states. - Policy question
- Which type of supervision is needed in order to
achieve a desired level of assets risk?
8Related literature
- Works that try to analyze the risk taking
motivation implied by the executive compensation - John, K., Saunders, A., and Senbet, L.W., (RFS,
2000), Sundaram, R., and Yermack, D., (JF, 2007)
and Raviv and Landskroner (Working paper, 2009) - Empirical papers that find evidence for the link
between executive risk taking motivation and the
state of the economy - Kempf et. Al., (JFE, 2009), Jacobson, LaLonde and
Sullivan (AER,1993), Sullivan and von Wachter (
QJE, 2009)
9Model Assumptions
- We consider a financial institution financed by
equity and deposits. - The deposits mature at time T and have a face
value of F (Merton (1974). - We assume that the executive compensation package
has three components that are sensitive to the
value of the financial institutions assets - Equity-based compensation
- Loss to firm-specific insolvency (ignored in the
guidelines) - Loss due to systemic crisis (ignored in the
guidelines, and also in academic research so far) - The executive chooses the level of asset risk
that would maximize the value of her compensation.
10Component 1 Equity-based compensation
- Includes any compensation component that has
positive sensitivity to an increase in the value
of the bank assets (VT) above the strike price
(H). - e.g., bonus payments, stocks, stock options
- The payoff from this component at maturity is
11Component 2 Loss due to firm-specific
insolvency
- Has a positive sensitivity to a decrease in the
value of the financial institutions assets (VT)
below the face value of the deposits (F).
Composed of - Unsecured defined benefit pension (Bebchuk and
Jackson, 2005, Sundaram and Yermack, 2007, and
Gerakos, 2007 and Edmans 2010). - Reputation effect the insolvency event may
reduce the future incomes of the executive.
(Gilson, 1989). - The payoff from this component at maturity is
12Component 3Loss due to systemic crisis
- Additional loss in value of an executives
compensation if the financial institution becomes
insolvent during a systemic crisis - Jacobson, LaLonde, and Sullivan (QJE, 1993),
Krebs (AER, 2007), Farber (2011). - ST value of the economic index at maturity
- K Threshold for systemic crisis
- 1 ? is the indicator function of the event ?.
13Component 3Loss due to systemic crisis
- A critical assumption in this paper is the
additional loss in the value of an executives
expected wealth from employment if the firm she
is managing becomes insolvent during a systemic
crisis. - This additional loss occurs because an
executives alternative employment opportunities
would be more limited during a systemic crisis. - We incorporate this loss in the model of
executive compensation in order to argue that
risk-taking incentives may be different under
good and bad states of economy.
14Empirical evidence Loss due to systemic crisis
- Jacobson, LaLonde and Sullivan (QJE, 1993)
- Find that employees that are displaced during
adverse labor market conditions have
significantly larger losses than workers those
displaced during good labor market conditions. - Davis and von Wachter (2012)
- Analyze the earnings losses of high-tenure
employees associated with job displacement They
find that in present value terms, earnings losses
from displacements that occur in recessions are
twice as large for displacements in expansions.
15Value of Executive Compensation
- The value of the executives compensation is
determined using standard option pricing theory. - The present value of the executives position is
Two Assets Correlation Put option
16Executives objective function
- The executive chooses the level of asset risk
that would maximize the value of her
compensation. - If the value of the compensation is monotonically
upward (downward) sloping with respect to the
asset risk, the executive would choose the
maximum (minimum) possible level of risk - Regulatory maximum
- If the value of compensation is a concave
function of asset risk, the executive would
choose an intermediate level of risk that would
yield the maximum compensation value. - Regulatory maximum, or executives choice
17Model Calibration
Baseline
a Sensitivity of compensation to equity-based compensation 2
b Sensitivity of compensation to firm-specific financial distress 1
g Sensitivity of the compensation to Loss due to systemic crisis 3
V Market value of the firm's assets 102.15
F Face value of firm's debt 100
LR Quasi-leverage ratio of the firm 0.95
S Level of the economic index 90 to 130
K Threshold of the economic index for systemic crisis 100
18Figure 1 Effect of loss due to firm-specific
insolvency (b)
- The equity-based compensation would pay, at
maturity, 2 of the fixed compensation for each
1 increase in the firms asset values above the
strike price (a 2). - The executive would lose b of the fixed
compensation for each 1 decrease in the firms
asset values below the face value of debt. - The parameter ? is set to 0.
19Implications Effect of leverage
- Table 1
- The level of asset risk that an executive would
optimally target depends on the financial
institutions leverage. - As the financial institutions leverage ratio
increases, the optimal asset risk decreases. - The negative relationship between leverage and
optimal asset risk level may partly explain the
credit freeze and flight-to-quality by financial
institutions during the 20072009 financial
crisis. - However, the model so far lacks the ability to
explain why financial institutions with
significantly different leverage ratios all
targeted very low levels of asset risk.
20Figure 2 Effect of loss due to systemic crisis
during good and bad times
- The economic index is located 30 above the
threshold of systematic economic crisis in good
times and 10 below the threshold in bad times. - Units of costs due to firm-specific insolvency
are equal to 1 (ß 1) and units of equity-based
compensation are equal to 2 (a 2).
21Figure 3 Value of executive compensation for
different levels of asset risk and different
states of the economy
- The economic index levels range from 30 above
the threshold of systemic economic crisis to 10
below the threshold. Units of costs due to
firm-specific insolvency are equal to 1 (ß 1)
and units of equity-based compensation are equal
to 2 (a 2).
22Optimal Asset Risk Levels for Different
Compensation Schemes, Firm Leverage Levels, and
States of the Economy
Stock Option Quantity Normalized Economic Index Bank Leverage Ratio Bank Leverage Ratio Bank Leverage Ratio Bank Leverage Ratio
Stock Option Quantity Normalized Economic Index 0.975 0.950 0.925 0.900
Panel A a 1 -10 1.40 3.05 4.62 6.21
Panel A a 1 0 1.40 3.05 4.62 6.22
Panel A a 1 10 1.41 3.08 4.67 6.28
Panel A a 1 20 1.45 3.18 4.83 6.49
Panel A a 1 30 1.56 3.50 5.31 7.14
Panel A a 1 ? 0 12.53 21.99 28.04 US
Panel B a 2 -10 1.97 4.27 6.45 8.64
Panel B a 2 0 1.98 4.32 6.52 8.74
Panel B a 2 10 2.08 4.56 6.89 9.22
Panel B a 2 20 2.47 5.64 8.60 11.53
Panel B a 2 30 US US US US
Panel B a 2 ? 0 US US US US
Panel B a 3 -10 3.02 6.52 9.75 12.92
Panel B a 3 0 3.22 7.01 10.48 13.87
Panel B a 3 10 5.19 US US US
Panel B a 3 20 US US US US
Panel B a 3 30 US US US US
Panel B a 3 ? 0 US US US US
23Extension 1 Default at Boom
- An executive will incur an additional loss if the
financial institution she is managing becomes
insolvent at a time of systemic economic boom. - A manager that fails during good economic times
would be sending the labor market a very bad
signal of her quality, because such a failure
would be an idiosyncratic event. - Calibration Jacobson, LaLonde and Sullivan
(1993) and Davis and von Wachter (2011) estimate
that the earnings loss from displacement during
recessions is twice of earnings loss from
displacement during expansions.
24Component 4Default at Boom
- Additional loss in value of an executives
compensation if the financial institution becomes
insolvent during a systemic boom time - ST value of the economic index at maturity
- KBoom Threshold for systemic boom time
- 1 ? is the indicator function of the event ?.
25Optimal Asset Risk for different size of default
in boom components, firm leverage, and States of
the Economy
Normalized Economic Index Bank Leverage Ratio Bank Leverage Ratio Bank Leverage Ratio Bank Leverage Ratio
Normalized Economic Index 0.975 0.950 0.925 0.900
Panel A d 0 -10 1.97 4.27 6.45 8.64
Panel A d 0 0 1.98 4.32 6.52 8.74
Panel A d 0 10 2.08 4.56 6.89 9.22
Panel A d 0 20 2.50 5.68 8.60 11.53
Panel A d 0 30 US US US US
Panel A d 0 ? 0 US US US US
Panel B d 1.5 -10 1.97 4.27 6.45 8.64
Panel B d 1.5 0 1.98 4.32 6.52 8.74
Panel B d 1.5 10 2.08 4.56 6.89 9.22
Panel B d 1.5 20 2.47 5.57 8.43 11.29
Panel B d 1.5 30 6.05 US US US
Panel B d 1.5 ? 0 US US US US
26Extension 2 Bankruptcy costs
- We incorporate bankruptcy costs in the model, in
which leverage has a significant effect on the
value of the financial institutions assets
through bankruptcy costs. - Higher leverage ratios translate into higher
default probabilities and increase the expected
value of bankruptcy costs, which in turn lead to
lower value of the financial institution. - Calibration we analyze the effect of bankruptcy
costs amounting to 2, 4 and 6 of the initial
value of the financial institutions assets
(Anderson and Sundaresan, 1996).
27Optimal Asset Risk for Different Bankruptcy Costs
and States of the Economy
Leverage Normalized Economic Index Bank Leverage Ratio Bank Leverage Ratio Bank Leverage Ratio Bank Leverage Ratio
Leverage Normalized Economic Index BC0 BC2 BC4 BC6
LR0.95 -10 4.27 2.96 2.43 2.19
LR0.95 0 4.32 2.97 2.43 2.19
LR0.95 10 4.56 3.03 2.44 2.20
LR0.95 20 5.64 3.36 2.51 2.22
LR0.95 30 US US US 2.32
LR0.90 -10 8.64 7.10 6.04 5.39
LR0.90 0 8.74 7.16 6.06 5.40
LR0.90 10 9.22 7.46 6.19 5.46
LR0.90 20 11.53 8.94 6.84 5.73
LR0.90 30 US US US US
28Extension 3 Early withdrawal of deposits
- The base assumption an annual audits process
(Marcus and Shaked, 1984 Ronn and Verma, 1986),
were default can occur only at debt maturity if
the value of the financial institutions assets
falls below the face value of debt (Merton,
1974). - Extension and calibration
- we instead consider the possibility of early
withdrawal of deposits were audit happens more
frequently - Information is raveled about the financial health
of the bank before debt maturity. - The default trigger would resemble a constant
barrier approach.
29Optimal Asset Risk for Different Audit Frequency,
Leverage and States of the Economy
Leverage Normalized Economic Index Audit frequency by the regulator Audit frequency by the regulator Audit frequency by the regulator
Leverage Normalized Economic Index Monthly Quarterly Yearly
LR0.95 -10 3.63 3.72 4.27
LR0.95 0 3.65 3.74 4.32
LR0.95 10 3.75 3.84 4.56
LR0.95 20 4.32 4.45 5.64
LR0.95 30 6.23 6.58 US
- All else equal, as the audit frequency gets
higher, risk-taking motivation of the executive
will decrease.
30Extension 4 Direct regulatory measures versus
regulation of compensation
31Extension 4 Direct regulatory measures versus
regulation of compensation
32Extension 4 Direct regulatory measures versus
regulation of compensation
- If the accumulated equity-based compensation is
falls short of the level that would achieve the
desired risk taking regulating executive
compensation may be a substitute to direct
regulatory measures such as capital adequacy
ratios. - If the accumulated incentives are already too
high there will still be a need for other
regulatory measures to restrict risk taking.
33Optimal Asset Risk Levels for Different
Compensation Schemes, Firm Leverage Levels, and
States of the Economy
Stock Option Quantity Normalized Economic Index Bank Leverage Ratio Bank Leverage Ratio Bank Leverage Ratio Bank Leverage Ratio
Stock Option Quantity Normalized Economic Index 0.975 0.950 0.925 0.900
Panel A a 1 -10 1.40 3.05 4.62 6.21
Panel A a 1 0 1.40 3.05 4.62 6.22
Panel A a 1 10 1.41 3.08 4.67 6.28
Panel A a 1 20 1.45 3.18 4.83 6.49
Panel A a 1 30 1.56 3.50 5.31 7.14
Panel A a 1 ? 0 12.53 21.99 28.04 US
Panel B a 2 -10 1.97 4.27 6.45 8.64
Panel B a 2 0 1.98 4.32 6.52 8.74
Panel B a 2 10 2.08 4.56 6.89 9.22
Panel B a 2 20 2.47 5.64 8.60 11.53
Panel B a 2 30 US US US US
Panel B a 2 ? 0 US US US US
Panel B a 3 -10 3.02 6.52 9.75 12.92
Panel B a 3 0 3.22 7.01 10.48 13.87
Panel B a 3 10 5.19 US US US
Panel B a 3 20 US US US US
Panel B a 3 30 US US US US
Panel B a 3 ? 0 US US US US
34Summary and Policy Implications
- The paper presents a quantitative framework to
calculate the level of asset risk that an
executive would choose under different - Compensation package
- Leverage
- State of the economy
- All else equal, as leverage ratio increases
executive would take less asset risk. - All else equal, as the state of the economy
deteriorates executive would take less asset
risk.