Convex payments Flashcards
What is the basic Principal - Agent problem?
The shareholder (owner) of a firm wants to incentivize the manager / CEO to put in sufficient effort, but the effort is not directly observed by the shareholder, or the cost of monitoring would be too high.
In what does the basic Principal - Agent problem result?
Asymmetric information and moral hazard.
After signing the contract the manager would rather put in less effort than more.
What can you observe as a shareholder?
The output (or profits). Higher effort e usually results in higher output, however there’s also a random factor c(e) determining the output (Y = e+ c)
What does concavity implies?
Risk aversion: would rather receive a fixed wage than a variable wage with the same expected value.
Disutility (cost) from effort c(e) is
Convex and increasing in effort e.
The marginal disutility is increasing. Hence after working as much as 80 hours you would like to spend time outside work
Holmstrom showd that the optimal incentive-compatible contract would be
A compensation rule w(y) depending output y such that:
- The manager accepts the offer (Participation Constraint, PC): EUmanager >û (the outside option of the manager)
- The manager prefers to put in high effort rather than low effort (Incentive Compatibility Constraint, ICC): EUmanager High >= EU manager Low
The basic Principal - Agent problem suggests that executive compensation should have
- Fixed part - high enough to satisfy Participation Constraint
- Variable part - pay that depends on the output. High enough to induce high effort, but not transfer too much risk to the agent.
The value of a convex payoff function increases with
uncertainty / volatility
Example: call option
When does Convex payoff function value volatility becomes a problem?
When the person on the receiving end of the convex payment function can actually influence the underlying riskiness. Examples: CEO, fund manager
Most financial incentives are
Convex
Convex incentives have mostly … and very little if any …
Convex incentives have mostly upside potential and very little if any downside
Short term incentives
Receiving a bonus when outperforming, but now the equivalent if under performing. Bonuses are rarely clawed back when performance declines afterwards.
Example of short-term incentives
Fund fees as a share of (positive) returns
Long-term incentives
Share call options allow CEO to benefit from the upside without downside risk.
Equity holdings themselves have unlimited upside, but only limited downside risk (share price cant go below 0)
Example of long-term incentives
convex fund inflows in investment fund
Incentives for fund managers are
Usually convex:
The 2-20 rule: 2% of AUM, 20% on excess returns.
Rewards gains, but does not symmetrically punish losses.
What does the 2% fee on AUM do?
Incentivizes managers to grow AUM
Fund inflows depend on
Previous year’s performance. Empirically, in a convex way:
Large inflows into funds that outperformed.
Not equivalent outflows out of funds that under performed.
What usually happens if people miss their target in the first half of the year? Found by Brown, Harlow and Starks
They increase their risk-taking in the second half.
Lin found that fund managers that are lagging start investing more in …
And the other way around?
- If underperform - Positively skewed assets (lottery-like)
2. If overperform - Negatively skewed assets
Figueiredo, Rawley and Shelef: What happens to fund managers strategies when they dip below their performance thresholds?
On average, risk-taking increases by 50%, while performance drop by 2,3%.
Although this effect diminishes when performance dips way below the threshold.
Risk-taking by banks: Chen et al. investigated the relation between option-based compensation and firm risk-taking for US banks and found
US banks have increasingly employed option-based compensation over the investigation period (1992-2000) and that has induced risk taking.
Did bonuses cause the financial crisis?
Not the ultimate cause, but may be
Balachandran et al. looked at bonus payments and risk of default of fin institutions and found
Equity pay (restricted stock and options) increase the probability of default, while cash bonuses actually decrease it.
Bebchuk et al. argue that actual remuneration practices
are not based on some kind of optimal incentive contract, but rather represent the abuse of management power
Optimal contract:
- Attracts and retains high quality executives
- Provides executives with incentives to provide sufficient effort
- Provides incentives to take decisions in the shareholders’ interest
- Minimizes overall costs
Mechanisms to assure Optimal Contracting
- Arms length boards: Board is not influenced by management to ensure contracts are inline with shareholders needs.
- Constraining market forces: Firms that don’t offer optimal contracts go out of business.
What is gift exchange and what can lead to it?
Board chairman appointed after CEO takes office support higher compensation packages for example.
It happens when the CEO sits on the nominating committee for new board members.
Being adversarial on compensation runs counter to
The “support or fire” model of corporate boards. Board members are usually executives themselves and so benefit from supporting the idea that executives should be rewarded well. Board members themselves are often not sufficiently incentivized.
Limitation of shareholder power
To overturn a board-approved pay package, have to show that the board violated its duty and one must show a reasonable doubt that the board did not act independently, which is very hard to do.
Shareholders can usually vote on option plans, but mostly only on the total amount of options issued, hence its a blunt instrument for reducing executive pay.
Managerial power approach (MPA)
Assumes that powerful CEOs are able to skew away from the optimal contract and thereby extract rents.
It predicts that compensation packages depend on CEO power (the num of shares CEO owns, ratio of independent/inside board members), num of board members that the CEO shares a personal affinity with
MPA: What is one limiting factor to the executive packages?
The outrage factor.
And firms that experienced negative publicity surrounding its compensation practices experienced smaller increases in compensation than other firms.
To minimize the outrage, there is a lot of reliance on
Compensation surveys and consultants. Compensation consultants are usually hired by the firm directly, and not the board.
And also a lot of attempts at “blurring” the details.
CEO pay is based on
Benchmarks, and not so much on performance
CEOs are being rewarded for
General stock market rises. Most compensation is not indexed to average or industry performance. Most option plans’ strike price is current share price at the moment of issue.
Resetting options
When share price declines, options are often reset in order to keep the executives incentivized. Executives are usually allowed to unwind options as soon as they are vested (assigned to them).
Reloading
Whenever an executive sells shares, they are often rewarded with new options
In an optimal contract you would reward the CEO based on
Performance, and NOT based on luck
Bertrand and Mulainathan researched CEO luck and found that:
Pay responds to at least 50% luck.
What is a way to deal with the short-term risk-taking incentives that bonus packages provide?
Clawback provisions - Originally those were tied to revisions of earlier financial statements, while recently those are tied to misstatement and fraud, but also performance: Bonuses being postponed for a number of years such that if the firms fails in the meantime the bonus is forfeited (confiskuvani).
What are forfeited bonuses tied to?
The continuing performance of certain investments.
TARP (Troubled Assets Relief Programme)
Part of the bailout of the fin sector after the crisis came with restrictions: only 2 types of compensation were allowed - base wage and restricted shares (capping 50% of the base wage). However, regulations only valid until bank pays back the bailout money.
Dodd-Frank Wall Street Reform and Consumer Protection Act (2010)
Applies to all financial firms in US.
“Say on Pay” provision - the Act will require that public companies hold a non-binding shareholder vote on the compensation of their named executives at least once every 3 years.
All fin institutions have to disclose any incentive-based remuneration that could either lead to a material financial loss to the fin institution or that leads to excessive remuneration.
Firms are prohibited from adopting any incentive plan that regulators determine could induce excessive risk-taking.
Dodd- Frank:
7 different regulators involved
- SEC
- The Fed
- The office of the comptroller of the currency
- The Office of Thrift Supervision
- The Federal Deposit Insurance Corporation
- The National Credit Union Administration
- The Federal Housing Finance Agency
Dodd- Frank prohibits
No explicit limit to remuneration but prohibits remuneration that is unreasonable or disproportionate to the amount, nature, quality, and scope of services performed.
Dodd- Frank: Firms need to identify individuals that
expose the firm to substantial risk, and 50% of their bonuses would be deferred (postponed) by at least 3 years, subject to clawback.
EU Regulations
CRD IV (2014): The ratio of variable/fixed remuneration capped at 1:1, and may be increased to 2:1 when a supermajority of shareholders approve. It only applies to material risk takers (the individuals that can affect the risk profile of the bank as a whole) 25% of variable pay may be discounted from this rule if it is deferred at least 5 years. At least 40% has to be deferred by at least 3 years. Up to 100% must be subject to clawback.
First results, EBA 2016
The average ratio of v/f salary was 65%, the average v/f paid to high earners ($1m+) dropped to 127% and the n of high earners has increased significantly.
Kleymenova and Tuna study effects of UK and EU bonus regulations and found:
- UK announcement was perceived positively (bank stocks up by 5%), while EU announcement was perceived negatively (bank stocks went down by 2.25%)
- Pay-performance sensitivity and firm risk went down.
- CEO turnover went up.
Dutch regulation
Since 2015, more restrictive than EU - 1:5 ratio, hence bonus is not allowed to exceed 20% of the fixed wage. It also applies to employees of foreign firms that are employed in the Netherlands. And it is made easier to claw back bonuses either because they were rewarded on the basis of false info or they go beyond reasonableness.
