Ex-ante Incentives Research Articles

Do voluntary corporate activities lead to reporting regulation? evidence from corporate social responsibility

ABSTRACT Governments and regulators often introduce reporting standards to encourage desirable corporate activities through increasing information quality. Firms that voluntarily take socially desirable activities directly benefit from these standards by being better able to distinguish them against rivals in the product market or with respect to investors. Using a cross-country panel dataset, we find that, at an annual frequency, Corporate Social Responsibility (CSR) reports increase the prevalence of voluntary CSR reporting standards, but little evidence that the converse is true. Thus, at least in the short-run, reporting standards act as an ex-post certification for firms with high CSR activity rather than as an ex-ante incentive for corporate behaviour.

Measuring the ex-ante incentive effects of creditor control rights during bankruptcy reorganization

A large theoretical literature studies the effects of creditor control during bankruptcy proceedings on firm outcomes. Empirical work in this area mainly examines reforms to creditor control rights during liquidation. In this paper, we use administrative microdata and exploit a legal reform in Denmark to provide the first causal estimates of creditor empowerment in reorganization-the complementary bankruptcy procedure to liquidation. We find that the Danish reform led to a sharp decline in liquidations. Although few insolvent firms make use of the new reorganization procedures, we show that solvent firms improved their financial management and increased employment and investment. The findings illustrate the empirical importance of reorganization rules on the incentives of stakeholders outside of bankruptcy.

The risk implications of the business loan activity in credit unions

US credit unions have been subject to a strict regulation of their commercial lending which included both requirements for enhanced organizational practices and a cap on the proportion of business loans relative to assets (imposed in 1998 by US Congress). Since 2003, however, these limitations have been steadily relaxed, a process which has resulted in an increase in credit union business lending activity. Using data from the universe of US credit unions we provide comprehensive evidence that expansion of the business loan portfolio increases the risk of the asset side of the credit union. This is the case even for credit unions which benefit from partnership with the SBA, for which we observe an initial increase in the risk of non-SBA backed loans (an overconfidence effect) which reverses over time (a learning effect). Our results suggest, furthermore, that the risk of business loans is exacerbated for credit unions which initiate their business loan activity and which do so rapidly. In the second part of our analysis we provide descriptive and quasi-experimental evidence that expansions of credit union activity into business loans are associated with lower subsequent growth rates of deposits. This result is similar to the reaction to risk indicators found in the banking literature and might give an ex-ante incentive for the CU that could work as a market-based stabilization mechanism complementary to that of explicit regulation.

Banking Access and Racial Inequality: Wealth and Human Capital Accumulation of Young Men

There are large racial differences in access to the financial system among young adults. Lack of access to savings and investment opportunities results in low financial returns on savings. Low returns, in turn, reduce ex-ante incentives to save, work, and invest in human capital. Using a structural model of schooling, labor supply, and savings with unequal financial access and endogenous borrowing constraints, I quantify the effects of racial differences in financial access and labor market discrimination on the observed racial wealth gap. Counterfactual policy experiments suggest that a financial inclusion policy that provides full access increases African American youths’ median net worth level and reduces racial wealth inequality. In comparison, a college tuition reduction policy is less effective in reducing wealth inequality.

Limits of Stress-Test Based Bank Regulation: Cues from the COVID-19 Crisis

Stress-tests provide complementary information about banks’ risk exposures. Recent empirical evidence, however, has uncovered potential inaccuracies in stress-test based assessments. We investigate the regulatory implications of these inaccuracies. Without stress-tests, the regulator cannot observe bank’s type, and sets the same requirement across banks. Stress-testing provides a noisy signal about the banks’ types, and enables bank specific surcharges, which can improve welfare. Yet, when stress-tests are less accurate, they distort banks’ ex-ante incentives to improve their risk-return profiles. As a result, higher capital surcharges can lead banks to be more risky. The optimal surcharge depends on the accuracy of stress-tests, and can be zero.

Do Reporting Requirements Encourage Voluntary Activities or Do Voluntary Activities Lead to Reporting Requirements? Evidence from CSR

Governments and regulators often impose reporting requirements for a specific class of activities, to encourage beneficial corporate behavior by increasing information quality through reporting standards. We find that Corporate Social Responsibility (CSR) reports tend to increase the prevalence of voluntary CSR reporting standards, but little evidence that the converse is true. Thus, at least in the short-run, reporting standards act as an ex-post certification rather than as an ex-ante incentive for corporate behavior.

Intellectual Property Protection in M&A Negotiations

In this paper, I show that a major share of the value of target firm’s intellectual property can be protected from expropriation by the acquirer through negotiating a compensating bidder termination fee (BTF), which is paid to the target in case the acquirer abandons the deal. I apply a capitalization model for intangible capital stocks to proxy for the component of intellectual property in target firm’s market value. The results suggest that, on average, for every dollar of target firm’s R&D capital stock, roughly 16 cents of protective share is incorporated in the BTF. I strengthen my causal interpretation with an instrument variables approach that exploits exogenous industry-level variation in R&D worker quota. The relation between target firm’s innovation activity and BTF size is more pronounced, if the target is a pioneer in its technology sector, if the target operates in an industry that sells unique products, if the target is assigned to the high-tech or healthcare industry, and if the target mentions “trade secrets” in its 10-K report filed with the SEC prior to deal announcement. The effect is further increasing in the degree of technological proximity as well as product market rivalry between acquirer and target. Extending prior research at the intersection of innovation, law, and M&A, this paper concludes that BTFs serve as a contract mechanism that provide target firms compensation for revelation of sensitive information in M&A negotiations if acquirers terminate deals. The option to include BTFs in M&A contracts thereby increases acquirers’ incentives to close the deal and increases targets’ ex-ante incentives to reveal innovative secret information.

Optimal Standards of Proof in Patent Litigation: Infringement and Non-Obviousness

We build a model of innovation and patent adjudication under two forms of uncertainty; uncertainty regarding whether the original invention merits protection (non-obviousness), and uncertainty as to whether a particular competitor's product should be barred (infringement). We find that when it is practical to increase the rewards from innovation by extending patent length, the standards of proof for non-obviousness should be high. The intuition for this is that patent length should be set so that the increase in innovation from extending patent length is balanced by the increase in deadweight loss from extending monopoly pricing. In this situation, the ex-ante cost of failing to protect a good patent is minimal, but there is substantial deadweight loss from protecting a bad patent. In contrast, if non-infringing competing inventions substantially decrease the original inventor's profits, it might be desirable to have a very low standard of proof for infringement, since the deadweight loss from an incorrect finding of infringement is mostly balanced out by the increased ex-ante incentive to invent.

Measuring the Ex-Ante Incentive Effects of Bankruptcy Reorganization Rules

A large theoretical literature studies the effects of creditor control during bankruptcy proceedings on firm outcomes. Empirical work in this area mainly examines reforms to creditor control rights during liquidation. In this paper, we use administrative microdata and exploit a legal reform in Denmark, to provide the first causal estimates of creditor empowerment in reorganization—the complementary bankruptcy procedure to liquidation. We find that the Danish reform led to a sharp decline in liquidations. Although few insolvent firms make use of the new reorganization procedures, we show that solvent firms improved their financial management and increased employment and investment. The findings illustrate the empirical importance of reorganization rules on the incentives of stakeholders outside of bankruptcy.

A Two-Sided Budget-Neutral Incentive Program for Coordinating an Influenza Vaccine Supply Chain With Endogenous Supply and Demand Under Uncertainty

Problem definition: The US influenza (flu) vaccine supply chain is decentralized and experiences frequent supply and demand mismatches caused by two key factors: (1) the vaccine production process (yield) is highly uncertain; and (2) individuals are self-interested and do not completely take into account positive and negative externalities that they impose on others. To improve matching of supply and demand, we counteract these factors by developing an ex-ante budget-neutral incentive program. Methodology: We model the flu vaccine supply chain as a decentralized system consisting of self-interested individuals on the demand side, and a profit-maximizing manufacturer with uncertain yield on the supply side. We use backward induction to characterize the subgame-perfect equilibrium of the sequential game that models the interactions between individuals and the manufacturer. Results: We develop a two-sided incentive program that proposes ‘vaccination incentives’ to be given to individuals on the demand side, and ‘a menu of transfer payments’ between the social planner and manufacturer on the supply side. When the realized vaccine supply is high (or low), our incentive program provides positive (negative) vaccination incentives for individuals to stimulate (or curb) the demand and eliminate positive (or negative) externalities by making vaccination more affordable (or costly). When social benefits from vaccination are significantly high, our incentive program uses a menu of transfer payments to penalize (or subsidize) the manufacturer for low (or high) yield realizations so that it produces the socially-optimal quantity. We show that our incentive program can attain the social optimum, maintain an ex-ante balanced budget (i.e., budget-neutral in expectation), and distribute the maximum social welfare between individuals and the manufacturer arbitrarily. Academic/practical relevance: We establish the sources of inefficiency in the flu vaccine supply chain. To eliminate the inefficiency, we develop a two-sided incentive program that policymakers can implement to finance vaccines under an ex-ante balanced budget. Managerial implications: Vaccination incentives to individuals can ensure their access to the vaccine, but they are not enough to entice the manufacturer to ensure vaccine availability. A menu of contracts contingent on realized yield provides necessary incentives to the manufacturer and assures the availability.

Modelling the effects of exposure to risk on junior faculty productivity incentives under the academic tenure system

This paper relies on modelling tools from probability theory and the economics of risk to analyze the ex-ante incentive properties of tenure from the perspective of junior faculty members. The theoretical results show that under publication value uncertainty and risk aversion, a junior faculty member publishes at a point where the expected value of publication exceeds the marginal cost of publication. In addition, under decreasing absolute risk aversion (DARA), increasing a junior faculty member's base salary reduces the implicit cost of private risk bearing thereby stimulating scientific productivity. However, increasing levels of uncertainty in the value of publication reduces faculty research incentives. These results have important implications for academic departments as they seek to enact effective policies to achieve and maintain their accreditation and reputation goals through maximum faculty productivity.

Payday Before Mayday: CEO Compensation Contracting for Distressed Firms

Using a sample of more than 1,500 US public firms in the period 1998-2016, we examine how firms endogenously adjust CEO compensation contracts when they become financially distressed. The link between compensation and equity-based measures of firm performance is positive and strong prior to distress, but declines and becomes insignificant when firms are in distress. However, the relationship of pay to cash flow performance remains positive for distressed firms. Directly examining the ex-ante incentives provided in contracts rather than ex-post payouts, we provide evidence that firms respond to the onset of distress by providing incentives oriented toward improving cash flows. Specifically, distressed firms increase their use of performance-based pay but re-orient performance metrics towards cash flow related measures and set performance targets farther above prior performance. Further, these firms reduce equity-oriented incentives by increasing the proportion of expected performance-based compensation to be paid in cash rather than stock. These changes are economically most important for firms with the greatest need to replace out-of-the-money equity-based incentives, and in the years immediately preceding an actual default or bankruptcy. Overall, our findings are consistent with agency theory predicting that reduced incentives require contract realignment of managers with relevant stakeholders of distressed firms.

Independent minority directors and firm value in a principal–principal agency setting: evidence from Italy

Following the agency theory, this paper contributes to the literature on board independence as a mechanism to mitigate agency costs by investigating the impact of independent minority directors on firm value in a principal–principal setting. Independent minority directors might alleviate agency costs associated to the risk of self-dealing transactions and, in turn, increase firm value. However, since non-controlling shareholders are also self-interested, particularly for firms characterized by strong uncertainty about future financial results and high information asymmetry, independent minority directors might negatively impact firm value by creating frictions within the board, increasing the risks of potential hold-ups by minority shareholders and limiting the ex-ante incentives of the block-holder to undertake profitable idiosyncratic investments. By examining a sample of Italian listed companies, we find some evidence about a positive relationship between the proportion of independent minority directors and firm value. Although weaker, a positive relationship between the proportion of independent minority directors and firm value is also found for firms characterized by high information asymmetry and—therefore—exposed to the risk of opportunistic actions by minority shareholders against the dominant shareholder. Our results shed new light on the relationship between board composition and firm value in a concentrated ownership setting, revealing the role played by independent minority directors in mitigating agency costs.

CEO Inside Debt and Firm's Maturity Structure of Debt

This study examines managerial compensation incentives and its impact on firm’s financial decisions. Specifically, we examine how CEO’s inside-debt based compensation incentives (pension benefits and other deferred compensation) influences firm’s debt maturity structure. We examine this relationship in the context of the hypothesis that CEO’s inside-debt based incentives exposes managers to similar kind of default risk as any other unsecured risky debt, which may change their risk preferences that may have an influence on firm’s financial decisions. Empirical evidence of this study supports a view that when manager’s ex-ante incentives for substituting risky assets over safe assets is low (that is, higher CEO-debt based incentives as compared to equity-based compensation incentives), creditors allow firms maintain long-maturity debt since high inside debt-based incentives can substitute for the monitoring incentive mechanism of short-term debt.

Executive Compensation, Bank-Owned Life Insurance, and Bank Holding Company Performance

Bank-owned life insurance (BOLI) is life insurance purchased by bank holding companies (BHCs) for key employees, whose proceeds can be shared by the company and employees' heirs. We investigate whether and how executive compensation affects BOLI and whether BOLI use affects BHC performance. Using a sample of 2,041 firm-year observations from 2004 through 2013, we find a statistically significant positive relation between CEO compensation and BOLI, supporting the notion that BOLI is a complement to other forms of compensation. Further, we provide evidence that increases in BOLI, both relative to total assets and relative to other BHCs, benefit shareholders. This suggests the incentive effect of BOLI on BHC executives outweighs the potential agency problem of BOLI. The results are robust across various measures of BOLI and model specifications. Our results imply that ex-ante incentives embedded in BOLI motivate BHC managers to enhance shareholder value.

Agency Business Cycles

We propose a new business cycle theory. Firms need to randomize over firing or keeping workers who have performed poorly in the past, in order to give them an ex-ante incentive to exert effort. Firms have an incentive to coordinate the outcome of their randomizations, as coordination allows them to load the firing probability on states of the world in which it is costlier for workers to become unemployed and, hence, allows them to reduce overall agency costs. In the unique robust equilibrium, firms use a sunspot to coordinate the randomization outcomes and the economy experiences endogenous, stochastic aggregate fluctuations.

Is Race- and Sex-Based Targeting Efficient? A Closer Look at Tort Law's Discriminatory Damage Awards

Inherent within current tort law are incentives to target individuals and communities based on race and gender. Surprisingly, the basis for this targeting is the seemingly neutral use of three different race- and gender-based statistical tables (for wages, life expectancy and worklife expectancy) which, when used in tort damage calculations, result in a large disparity between damages awarded to whites versus blacks, and men versus women. Thus, tort law’s remedial damage scheme perpetuates existing racial and gender inequalities by compensating individuals, especially children, based on their race and gender. Even worse, tort law creates ex-ante incentives for potential tortfeasors to engage in future discriminatory targeting of women and minorities. This paper provides the first full account of courts' existing discriminatory practices. The paper then addresses the deficiencies in the non-blended tables that courts use (tables that use race and gender as discriminating factors) and the reasons behind their continued use. The paper shows how the various theories of tort law (corrective justice, distributive justice, and economic efficiency) have contributed to a misunderstanding of the proper damages calculation, and illustrates how the very same theories can be used to engender a change in the current praxis. It then challenges the conventional wisdom that the use of race- and gender-based tables is justified on efficiency grounds, pointing out fatal flaws inherent in the tables, in how they are used in courts to calculate damages for individuals, and in the incentives they create. The paper then reveals that similar discriminatory practices ironically exist in federal law such as the Americans with Disabilities Act and even Title VII whose main goal is to combat gender and race discrimination. Finally, this paper proposes a feasible, low cost, and logical solution that pushes toward a more efficient and less discriminatory tort law remedial system: courts should immediately stop using non-blended tables.

Competitive microcredit markets: differentiation andex anteincentives for multiple borrowing: Fig. 1

We analyze an oligopolistic microcredit market characterized by asymmetric information and institutions that can offer only one type of contract. We study the effects of competition on contract choice when small entrepreneurs can borrow from more than one institution due to the absence of credit bureaus. We show that appropriate contract design can eliminate the ex-ante incentives for multiple borrowing. Moreover, when the market is still largely unserved and particularly risky, a screening strategy leading to contract differentiation and credit rationing is unambiguously the most effective to avoid multiple borrowing.

Who Monitors the Monitor? Bank Capital Structure and Borrower Monitoring

The role that banks play in screening and monitoring their borrowers is well understood. However, these bank activities are costly and unobservable, thus difficult to contract upon. This introduces the possibility of shirking and leads to the question – who monitors the monitor? Financial intermediation theories posit that bank capital structure plays such a role in incentivizing banks to monitor their borrowers. Both bank debt and bank equity have been proposed in various theories as providing the discipline to induce banks to monitor. However, empirical evidence on how bank capital structure influences borrower monitoring is scant. To circumvent identification concerns with regressing (unobservable) bank monitoring on (endogenous) bank capital structure, we use variation in country-level creditor rights to capture banks’ need to monitor their borrowers. We develop a theoretical model in which greater expost protection offered to lenders (i.e., banks) during borrower bankruptcy/renegotiation reduces the bank’s ex-ante incentives to monitor. This is because the greater salvage value of bank loans reduces the bank’s expected loss from not monitoring. Our model also examines how banks alter their capital structures in response to changes in their country’s creditor rights, and shows that the reduced demand for bank monitoring induced by stronger creditor rights induces the bank to shift its capital structure away from the source of financing that induces it to monitor. We find empirically that increases in creditor rights result in banks tilting their capital structures away from equity and towards deposits. We verify (theoretically and empirically) that these demand-based tilts in bank capital structure are not explained by supply-side effects (i.e., creditor rights make it cheaper to supply bank debt), and conclude that bank equity is a stronger source of discipline on banks than bank debt.

Renegotiation-Blocking

Renegotiation of contractual agreements may lead to distortion of ex-ante incentives and inefficiencies. However, this problems can be circumvented in a credible way by the use of financial claims. The contracting parties ask financial markets (external claimants) to issue financial claims which are redeemable in the event of renegotiation. If the contracting parties do not know exactly how many claims have been issued, then this source of asymmetric information causes the failure of any renegotiation attempt. Moreover, by construction, the renegotiation blocking process does not generate additional inefficiency.