The Effect of High Power Financial Incentives on Excessive Risk-Taking Behavior: An Experimental Examination

Abstract

ABSTRACTRecent attempts by policy makers to rein in high power financial incentives are predicated on the belief that such incentives cause managers to engage in excessive risk taking that is not in the best interest of the firm. This potential agency cost, however, has received little attention in the management accounting literature. We examine the effect of incentive power on excessive risk-taking behavior in a controlled experimental setting where managers make incentivized risk choices that affect the pay of the manager and another participant representing the firm. Our main results are, first, that the high power incentive generates more excessive risk taking than the low power incentive, despite both incentives being equivalent in expected value at the optimal level of risk for the firm. Second, changing from the low power to the high power incentive significantly increases excessive risk taking, but changing from the high power to the low power incentive does not significantly decrease excessive risk taking, indicating a stickiness effect that may hinder attempts to decrease this behavior. These results provide useful insights for agency theory and public policy.JEL Classifications: C91; C92; D80; G30; J30; M40.