Troubled Asset Relief Program and earnings informativeness

Abstract

PurposeThe purpose of this paper is to examine restrictions placed by the Troubled Asset Relief Program (TARP) on executive compensation during the financial crisis. Since it remains unclear if TARP restored public confidence in financial institutions, the authors also analyze what effect such regulations had on investors’ confidence in the information provided by earning with respect to executive compensation during this critical period.Design/methodology/approachTo test the assertions, the authors employ an Earnings Response Coefficient model, which captures the association between firms’ earnings surprise (ES) and perceived earnings informativeness. The authors implement both a long- and short-window test to obtain a better understanding of the effects of TARP on financial institutions’ earnings informativeness. The authors use the long-window approach to gather evidence about whether and how financial institutions’ ES are absorbed into security prices conditional on both their participation in TARP and their compliance with TARP’s compensation restrictions. The authors attempt to establish a stronger causal link by also using a short-window approach.FindingsThe authors find that firms paying their CEOs above the TARP threshold show higher earnings informativeness. Financial institutions that paid their CEOs above the TARP threshold achieved better performance during their participation in TARP. The authors also find that a decrease in total compensation while participating in TARP is associated with improved earnings informativeness. Lastly, separating total compensation into its cash and stock-based components, the authors find that firms improve earnings informativeness when they increase (decrease) cash (performance) compensation during TARP. However, overall earnings informativeness decreases during and after TARP relative to the pre-TARP period.Practical implicationsThe research suggests that executive compensation incentives affect earnings informativeness and that tradeoffs are made between direct and indirect costs in retaining executives. The results have implications for policy makers, investors and researchers because the results allow policy makers and regulators to improve on how they design and implement accounting, market and finance regulations and reforms. Investors may potentially use the results when evaluating firm experiencing financial and, in some case, political distress. It also helps firms and offering optimal compensation contracts to create proper incentives for executives and ensure that managerial actions result in successful firm performance.Social implicationsThe study shows how firms react to changing regulations that affect executive compensation and earning informativeness. The results of the study allow regulators to potentially design more effective regulations by targeting certain aspects of firms’ operation such excessive risk-taking behavior and rent extraction opportunities.Originality/valueThere are very few studies that deal with how firms react to regulation that affect executive compensation. The authors provide evidence regarding what effect TARP and its compensation restrictions had on financial institutions’ earnings informativeness. The evidence in the study will further regulators’ understanding of whether TARP improved investors’ confidence in financial institutions. The paper also contributes to the understanding in how changes in executive compensation in times of high political scrutiny affect investors’ perceptions of firm performance.