Convex payments

Question 1

What is the basic Principal - Agent problem?

Answer 1

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.

Question 2

In what does the basic Principal - Agent problem result?

Answer 2

Asymmetric information and moral hazard.

After signing the contract the manager would rather put in less effort than more.

Question 3

What can you observe as a shareholder?

Answer 3

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)

Question 4

What does concavity implies?

Answer 4

Risk aversion: would rather receive a fixed wage than a variable wage with the same expected value.

Question 5

Disutility (cost) from effort c(e) is

Answer 5

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

Question 6

Holmstrom showd that the optimal incentive-compatible contract would be

Answer 6

A compensation rule w(y) depending output y such that:

1. The manager accepts the offer (Participation Constraint, PC): EUmanager >û (the outside option of the manager)
2. The manager prefers to put in high effort rather than low effort (Incentive Compatibility Constraint, ICC): EUmanager High >= EU manager Low

Question 7

The basic Principal - Agent problem suggests that executive compensation should have

Answer 7

1. Fixed part - high enough to satisfy Participation Constraint
2. Variable part - pay that depends on the output. High enough to induce high effort, but not transfer too much risk to the agent.

Question 8

The value of a convex payoff function increases with

Answer 8

uncertainty / volatility

Example: call option

Question 9

When does Convex payoff function value volatility becomes a problem?

Answer 9

When the person on the receiving end of the convex payment function can actually influence the underlying riskiness. Examples: CEO, fund manager

Question 10

Most financial incentives are

Answer 10

Convex

Question 11

Convex incentives have mostly … and very little if any …

Answer 11

Convex incentives have mostly upside potential and very little if any downside

Question 12

Short term incentives

Answer 12

Receiving a bonus when outperforming, but now the equivalent if under performing. Bonuses are rarely clawed back when performance declines afterwards.

Question 13

Example of short-term incentives

Answer 13

Fund fees as a share of (positive) returns

Question 14

Long-term incentives

Answer 14

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)

Question 15

Example of long-term incentives

Answer 15

convex fund inflows in investment fund

Question 16

Incentives for fund managers are

Answer 16

Usually convex:
The 2-20 rule: 2% of AUM, 20% on excess returns.
Rewards gains, but does not symmetrically punish losses.

Question 17

What does the 2% fee on AUM do?

Answer 17

Incentivizes managers to grow AUM

Question 18

Fund inflows depend on

Answer 18

Previous year’s performance. Empirically, in a convex way:
Large inflows into funds that outperformed.
Not equivalent outflows out of funds that under performed.

Question 19

What usually happens if people miss their target in the first half of the year? Found by Brown, Harlow and Starks

Answer 19

They increase their risk-taking in the second half.

Question 20

Lin found that fund managers that are lagging start investing more in …
And the other way around?

Answer 20

1. If underperform - Positively skewed assets (lottery-like)

2. If overperform - Negatively skewed assets

Question 21

Figueiredo, Rawley and Shelef: What happens to fund managers strategies when they dip below their performance thresholds?

Answer 21

On average, risk-taking increases by 50%, while performance drop by 2,3%.
Although this effect diminishes when performance dips way below the threshold.

Question 22

Risk-taking by banks: Chen et al. investigated the relation between option-based compensation and firm risk-taking for US banks and found

Answer 22

US banks have increasingly employed option-based compensation over the investigation period (1992-2000) and that has induced risk taking.

Question 23

Did bonuses cause the financial crisis?

Answer 23

Not the ultimate cause, but may be

Question 24

Balachandran et al. looked at bonus payments and risk of default of fin institutions and found

Answer 24

Equity pay (restricted stock and options) increase the probability of default, while cash bonuses actually decrease it.

Question 25

Bebchuk et al. argue that actual remuneration practices

Answer 25

are not based on some kind of optimal incentive contract, but rather represent the abuse of management power

Question 26

Optimal contract:

Answer 26

1. Attracts and retains high quality executives
2. Provides executives with incentives to provide sufficient effort
3. Provides incentives to take decisions in the shareholders’ interest
4. Minimizes overall costs

Question 27

Mechanisms to assure Optimal Contracting

Answer 27

1. Arms length boards: Board is not influenced by management to ensure contracts are inline with shareholders needs.
2. Constraining market forces: Firms that don’t offer optimal contracts go out of business.

Question 28

What is gift exchange and what can lead to it?

Answer 28

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.

Question 29

Being adversarial on compensation runs counter to

Answer 29

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.

Question 30

Limitation of shareholder power

Answer 30

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.

Question 31

Managerial power approach (MPA)

Answer 31

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

Question 32

MPA: What is one limiting factor to the executive packages?

Answer 32

The outrage factor.
And firms that experienced negative publicity surrounding its compensation practices experienced smaller increases in compensation than other firms.

Question 33

To minimize the outrage, there is a lot of reliance on

Answer 33

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.

Question 34

CEO pay is based on

Answer 34

Benchmarks, and not so much on performance

Question 35

CEOs are being rewarded for

Answer 35

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.

Question 36

Resetting options

Answer 36

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).

Question 37

Reloading

Answer 37

Whenever an executive sells shares, they are often rewarded with new options

Question 38

In an optimal contract you would reward the CEO based on

Answer 38

Performance, and NOT based on luck

Question 39

Bertrand and Mulainathan researched CEO luck and found that:

Answer 39

Pay responds to at least 50% luck.

Question 40

What is a way to deal with the short-term risk-taking incentives that bonus packages provide?

Answer 40

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).

Question 41

What are forfeited bonuses tied to?

Answer 41

The continuing performance of certain investments.

Question 42

TARP (Troubled Assets Relief Programme)

Answer 42

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.

Question 43

Dodd-Frank Wall Street Reform and Consumer Protection Act (2010)

Answer 43

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.

Question 44

Dodd- Frank:

7 different regulators involved

Answer 44

1. SEC
2. The Fed
3. The office of the comptroller of the currency
4. The Office of Thrift Supervision
5. The Federal Deposit Insurance Corporation
6. The National Credit Union Administration
7. The Federal Housing Finance Agency

Question 45

Dodd- Frank prohibits

Answer 45

No explicit limit to remuneration but prohibits remuneration that is unreasonable or disproportionate to the amount, nature, quality, and scope of services performed.

Question 46

Dodd- Frank: Firms need to identify individuals that

Answer 46

expose the firm to substantial risk, and 50% of their bonuses would be deferred (postponed) by at least 3 years, subject to clawback.

Question 47

EU Regulations

Answer 47

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.

Question 48

First results, EBA 2016

Answer 48

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.

Question 49

Kleymenova and Tuna study effects of UK and EU bonus regulations and found:

Answer 49

1. UK announcement was perceived positively (bank stocks up by 5%), while EU announcement was perceived negatively (bank stocks went down by 2.25%)
2. Pay-performance sensitivity and firm risk went down.
3. CEO turnover went up.

Question 50

Dutch regulation

Answer 50

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.