EXECUTIVE%20COMPENSATION,%20RISK%20TAKING%20and%20THE%20STATE%20OF%20THE%20ECONOMY

1
EXECUTIVE COMPENSATION, RISK TAKINGandTHE STATE
OF THE ECONOMY

• Alon Raviv (Bar Ilan University)
• Elif Sisli-Ciamarra (Brandeis University)
• Ackerman Conference on Corporate Governance
• Dec 2012

2
The 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.

3
The 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

4
Regulating 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?

5
Regulating 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.

6
In 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.

7
Main 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?

8
Related 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)

9
Model 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.

10
Component 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

11
Component 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

12
Component 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 ?.

13
Component 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.

14
Empirical 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.

15
Value 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
16
Executives 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

17
Model 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
18
Figure 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.

19
Implications 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.

20
Figure 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).

21
Figure 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).

22
Optimal 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
23
Extension 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.

24
Component 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 ?.

25
Optimal 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
26
Extension 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).

27
Optimal 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
28
Extension 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.

29
Optimal 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.

30
Extension 4 Direct regulatory measures versus
regulation of compensation
31
Extension 4 Direct regulatory measures versus
regulation of compensation
32
Extension 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.

33
Optimal 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
34
Summary 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.