Academic journal article Journal of Economics and Finance

Performance Compensation Contracts and Ceos' Incentive to Shift Risk to Debtholders: An Empirical Analysis

Academic journal article Journal of Economics and Finance

Performance Compensation Contracts and Ceos' Incentive to Shift Risk to Debtholders: An Empirical Analysis

Article excerpt

Abstract

The paper investigates the relationships among CEO incentive contracts, manager ownership, charter value, and bank risk taking. We analyze whether the presence and magnitude of incentive contracts induce CEOs of financially distressed firms and firms with high manager ownership to take unprofitable risks that shift wealth from debtholders to equity holders. Our sample focuses on banks that had both the incentive and opportunity to shift risks, and compares them with those that did not. We compare weak and strong banks in periods when the banks' principal creditor, the FDIC, was a lenient and then a stringent monitor. The evidence is consistent with bonus compensation inducing CEOs of financially weak firms to shift risk to debtholders only if they do not have large insider ownership. The evidence is also consistent with these contracts rewarding CEOs for their effort to manage unforeseeable risk albeit not their ability. Low charter value banks with high managerial ownership took profitable risk during the lenient regulatory period. (JEL G30, G34)

Introduction

It is widely accepted that debt potentially changes stockholders' choice of operating policies for their businesses [e.g., Fama and Miller (1972), Jensen and Meckling (1976), Myers (1977), Barnea et al. (1980, 1985), Haugen and Senbet (1981), Berkovitch and Kim (1990), Campbell and Kracaw (1990), Moshe and Maksimovic (1990), and Mallo and Parsons (1992)]. Authors of these papers (among others) call attention to stockholders' incentive to shift risks to in-place debtholders, thereby transferring wealth to themselves. However, CEOs of publicly traded corporations may be unwilling to make investments that shift risk to debtholders, because the CEOs' interests are not or cannot be sufficiently well aligned with those of stockholders.1 Perhaps for this reason, numerical analyses presented by Parrino and Weisbach (1999) indicate that potential risk shifting is unlikely to have an economically significant effect on the investments of large, publicly traded non-financial corporations, except among corporations with high debt/equity ratios.

We provide an empirical test of whether incentive compensation is related to an increase or decrease of risk with a unique sample of 141 highly levered firms (banks), many of which had considerable incentives and opportunity to shift risk. The depleted capital of these banks (as indicated by their low market-to-book value of equity ratios and, thus, reduced unrecorded charter values) during the period we study (1988-1994) may have enhanced their managers' incentives to increase the variance of their banks' expected cash flows and unprofitable risk taking, especially considering that the nature of bank investments allows them to shift to riskier investments quickly.2 In addition, our sample meets an important criterion mentioned by Quay (1999), who argues that inclusion of failed firms or firms with severe financial problems is a necessary condition for testing risk shifting. During the seven years, 39 of the banks we study were "financial failures": liquidated, sold, or merged under conditions of severe financial distress. Our focus on these firms in a period when their industry was distressed (1988-91) allows for the possibility that future good performance was not the main reason that these firms adopted or maintained incentive compensation.3

To examine CEOs' risk shifting incentives, we contrast periods when creditors were first lenient and then stringent monitors and enforcers of risk taking. Prior to enactment of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), the banks' principal creditor, the Federal Deposit Insurance Corporation (FDIC), was a lenient monitor of risk taking.4 Similar to the ability of creditors to intervene when firms are contemplating debt restructure or bankruptcy, FDICIA gave the banking agencies both the mandate and power to stringently monitor and constrain risk-taking by financially weak banks. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.