Risk Incentives Research Articles

The interaction between equity-based compensation and debt in managerial risk choices

This paper examines the risk incentives of traditional and non-traditional call options in the context of a levered firm where managers under-invest due to risk aversion. Our results contrast with those presented in the literature inasmuch as lookback calls do not always induce higher risk taking than regular calls, and managers always prefer a combination of regular calls and shares of stock in their compensation package as opposed to only company shares. We also show that Asian options outperform both plain-vanilla and other nonstandard options in inducing higher risk taking and, thereby, are a superior remedy for alleviating the agency costs of deviating from the optimal volatility level. Finally, we shed new insights that better clarify the incorrect arguments found in the literature regarding the delta of regular and lookback calls.

CEO Risk Incentives and Innovation Premium*

AbstractWe investigate the relationship between CEO risk incentives and the innovation premium (IP) proposed by Forbes. We suggest that compared to traditional proxies of innovation, the IP is a comprehensive measure of a firm's overall innovation and, therefore, can measure innovation effectiveness in broader industries. We find that both option vega and vega‐to‐delta ratio, as measures of CEO risk incentives, have a positive relationship with the IP. Additional tests reveal that the traditional patent‐related outputs are also motivated by CEO risk incentives, but only in the IT industry. Overall, our findings are consistent with (1) the empirical evidence of Coles et al. (2006, Journal of Financial Economics 79, 431) that a higher vega after controlling for delta motivates managers to implement riskier policy choices and (2) the argument (Dittmann et al. 2017, Review of Finance 21, 1805) that the strength of the risk‐taking incentive relative to the performance‐based incentive, the vega‐to‐delta ratio, captures CEO risk‐taking incentives more accurately.

The economic incentive for risk taking in professional partnerships

Professional service firms are common in some areas, in particular auditing and law. They are organized as partnerships, private corporations, or public corporations. This paper discusses the first category of these three. When a partner leaves the partnership, her/his shares are redeemed. Two alternatives for redemption are at book value, the traditional alternative, or at fair market value. By means of a novel discounted dividends model that includes risk taking, it is shown that there may be an economic incentive for risk taking when the redemption value is equal to book value. There may also be an incentive for risk taking when the redemption value is equal to fair market value. However, the level of risk taking in the latter alternative is not higher than the level of risk taking in the former alternative. Switching from book value to fair market value as redemption value is hence suggested as one way to reduce client propensity for litigation. This paper’s incentive for risk taking in a professional partnership has apparently not been noted in the literature.

Robust incentives for risk

This paper studies a moral hazard problem wherein the principal is uncertain about the agent’s risk preferences and production technology. The principal, desiring robustness, evaluates contracts according to their worst case payoff against the set of preferences and technologies that satisfy her assumptions about the agent and his capabilities. We show that contracts which exhibit robustness to severe risk taking behavior (i) pay their smallest transfer for all outputs below some lower threshold and (ii) pay their largest transfer for all outputs above some upper threshold. In our main result, we identify a class of environments in which two-wage binary bonus contracts are robustly optimal.

Restructuring Lessons from the Covid Pandemic: Bail-Out vs. Market Approach

Bail-out, bail-in, or restructuring? In this article, we argue that restructuring has its rightful place in macro crises, such as the Covid pandemic. A policy that primarily focuses on insolvency avoidance and bail-outs is misled as it creates unwanted risk incentives, distorts market selection and resource allocation, and reduces beneficial transformative pressure. As a crisis typically goes hand in hand with new and fundamental developments, the changing environment should be met by competitive innovation. Bail-outs which tend to preserve the status-quo may be justified as part of a comprehensive emergency strategy and to overcome temporary market dysfunction. Such a response strategy, however should always be designed in concert with restructuring options. We propose amendments to the German insolvency and restructuring laws to address the shortcomings of restructuring/insolvency uncovered during the Covid pandemic. The goal is to improve the restructuring/insolvency regime so that it can better deal with the specific challenges of macro crises.

Ratings-based Regulation and Systematic Risk Incentives

Ratings-based Regulation and Systematic Risk Incentives

Do subsidy increases promote or inhibit innovation? Evidence from Chinese enterprises listed on the SSE STAR Market

PurposeThis study aims to comprehensively investigate the relationship between government subsidies and innovation performance in Chinese enterprises listed on the SSE STAR Market.Design/methodology/approachAn unbalanced sample, covering 285 observations in 215 enterprises listed on the SSE STAR Market from 2019 to 2020, was used to explore the relationships between government subsidies, R&D investment, CEO shareholding and innovation performance. Counterfactual analysis is added for robustness testing.FindingsEmpirical evidence confirms that government subsidies have an inverted U-shaped relationship with R&D investment and innovation performance. Meanwhile, R&D investment is a mediating variable between government subsidies and innovation performance. Moreover, CEO shareholding plays a moderating role between government subsidies and R&D investment. The higher the CEO ownership, the steeper the inverted U-shaped relationship.Practical implicationsThe government should introduce a dynamic mechanism to reasonably control subsidy amounts and strengthen the supervision of subsidy use. Enterprise managers should be aware of how incentives affect the firm’s innovation and implement a coordinated development of government subsidy policies and internal enterprise governance.Originality/valueThis study adds new empirical evidence for the relationship between government subsidies and enterprise innovation performance. The risk incentive provided by stock options is an important micro mechanism to compensate for the lack of government subsidies. The study identifies ways to promote firm innovation based on the synergistic effect of internal and external mechanisms.

Risk-Oriented Efficiency Assessment within the Level of Capitalization for Financial Institutions: Evidence from Turkish Securities Firms

Securities firms are the leading institutions that facilitate the flow of funds by performing key services both in primary and secondary markets. The assessment of the efficiency of these firms has become a contemporary major issue due to the increasingly intense competition, globalization, and innovation in capital markets. As part of the nature of the business environment for such firms, risk-taking behaviors play a key role in their efficiency. In addition, the level of capitalization has become a more critical tool to counterbalance risk and efficiency. Therefore, we aimed to assess the relationship between efficiency, risk, and the level of capitalization in a sample of Turkish securities by covering the detailed data of securities firms between 2004 Q1 and 2021 Q4. After employing a three-stage least-squares method in a panel-data framework, the empirical findings showed that there was a positive and significant relationship between the risk incentive and efficiency in the brokerage industry, which implied that firms can improve their efficiency through a more diversified portfolio. We further report that there was also a positive and significant relationship between securities firms’ risk incentives and capital that could be explained by the higher risky-asset ratio needed for larger amounts of capital to compensate for losses. These results have potentially important implications for the brokerage industry’s prudent supervision and underlined the importance of attaining long-term efficiency gains to support the development of capital markets.

The Effect of Banking Deregulation on Borrowing Firms' Risk‐Taking Incentives*†

ABSTRACTWe examine how regulatory restrictions on capital market activity affect the compensation contracting environment within firms. This study aims to expand our understanding of how financial market development affects firm risk‐taking via management compensation designs. Specifically, taking advantage of the staggered implementation of the Interstate Banking and Branching Efficiency Act (IBBEA), which increases bank competition and loan geographical diversification, this study examines how borrowing firms' compensation structures change when banks increase risk tolerance in their loan portfolios. Using hand‐collected compensation data of firms with market capitalization less than $75 million, we hypothesize and find that borrowing firms are likely to increase risk incentives after IBBEA and that this increase is more pronounced for firms located in states with less banking competition in the pre‐IBBEA period. We also show the findings to be more significant for borrowers whose lenders acquire more diversification benefits after IBBEA. These findings suggest that following deregulation, when banks face increased competition as well as an enhanced ability to diversify their credit risk geographically, these same banks tend to increase their tolerance for borrowers' risk‐taking. That is, their clients—nonfinancial firms borrowing from them—adjust their compensation contracts that are previously constrained by bank distaste for risk. We also document that firms that increase their risk incentives the most invest more in R&D, suggesting that management compensation is a complementary channel through which IBBEA affects firm innovation.

Black economic empowerment regulation and risk incentives

After the fall of apartheid in South Africa, Black Economic Empowerment emerged as a central policy, aimed at redressing the imbalances of the past by fairly transferring financial and economic resources to the majority of its citizens. Corporations voluntarily conduct Black Economic Empowerment deals in response to regulatory constraints designed to incentivize firms to draw in previously disadvantaged citizens as shareholders without the need for them to provide much initial capital. We develop a dynamic model of corporate structure, in which the claims held by all participants are carefully valued. The regulations have succeeded in bringing in new investors. We explore why different types of firms have structured deals in different ways and we identify unintended consequences of the regulations. In particular, these deals induce wrong-way risk resulting in shareholders becoming risk-averse. The implications of these regulations and the resulting wrong-way risk are fully explored.

The mechanism for SMEs growth by applying stochastic dynamical approach

The purpose of this paper is to establish an interpretable framework to describe the growth mechanism of small and micro enterprises (SMEs) under the tech-economic paradigm and develop a new measurement method for growth performance. Based on stochastic resonance theory, as the inherent capital–product switches are applied with capital driving and risk incentive, SMEs’ growth might exhibit an optimal state subject to the implementation of different strategies. Simulation results verify these strategies from management orientation, specialization level, and environmental uncertainty to reveal some nonintuitive phenomena. These findings lead us to create useful decision rules in risk management, growth path optimization or SME loans. Finally we wish the framework established in this paper may provide another new mathematical way to explain Schumpter’s economic development theory based on SMEs growth with innovation.

Determinants of CoCo issuance: liquidity and risk incentives

PurposeThis paper aims to study the impact of (regulatory and nonregulatory) liquidity on contingent convertible (CoCo) issuance and the relationship between CoCos and asset quality.Design/methodology/approachThe analysis of this study comprises two stages. In the first stage, the authors used a logit model to test whether banks with riskier assets as well as lower solvency and (regulatory and nonregulatory) liquidity are more likely to issue CoCos. In the second stage, the authors used univariate analysis and fixed effects regression to measure the impact of Additional Tier 1 (AT1) CoCos on the quality of the issuer’s assets.FindingsThe study shows that regulatory liquidity ratios are negatively related to CoCo issuance. This study also finds that the likelihood to issue CoCo is higher when banks have lower regulatory capital or are less risky. Asset quality is found to not change significantly after the issuance. All in all, these results suggest that while solvency regulation is primarily regarded as the main motivation for CoCo issuance, liquidity regulation also matters.Research limitations/implicationsDespite the fact that CoCos have been emerging as an alternative way to help banks meet regulatory capital requirements, the paper argues that the relation between liquidity regulation and CoCos should be taken into account.Originality/valueThis study presents an empirical analysis on the CoCos instrument, focusing on the relationship between AT1 CoCos and liquidity regulation. Therefore, it serves to fill a gap in the literature on the underlying forces behind CoCo issuance. Moreover, this study measures the impact of AT1 CoCos issuance on bank risk, particularly on the quality of the issuer’s assets.

Bank use of sovereign CDS in the Eurozone crisis: Hedging and risk incentives

Using a comprehensive dataset from German banks, we document the usage of sovereign credit default swaps (CDS) during the European sovereign debt crisis of 2008–2013. Banks used the sovereign CDS market to extend, rather than hedge, their long exposures to sovereign risk during this period. Lower loan exposure to sovereign risk is associated with greater protection selling in CDS, the effect being weaker when sovereign risk is high. Bank and country risk variables are mostly not associated with protection selling. The findings are driven by the actions of a few non-dealer banks which sold CDS protection aggressively at the onset of the crisis, but started covering their positions at its height while simultaneously shifting their assets towards sovereign bonds and loans. Our findings underscore the importance of accounting for derivatives exposure in building a complete picture and understanding fully the economic drivers of the bank-sovereign nexus of risk.

The Good, the Bad, and the Missed Boom

Abstract Some credit booms result in financial crises. While excessive risk-taking could plausibly explain the boom-to-bust cycle, many investors do not anticipate increasing risk. We show that credit booms may be misunderstood as being driven by high productivity because opaque bank assets disguise risk incentives. Balanced funding relative to productive prospects can sustain prudent lending (good boom), whereas funding imbalances may induce high risk exposure and boost asset prices (bad boom) or lead to asset underpricing and insufficient lending (missed boom). Rational agents drawing inference from prices make mistakes that can amplify the effect of funding imbalances and propagate risk. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Market discipline and capital buffers in Islamic and conventional banks in the MENA region

This paper examines the effectiveness of market discipline in motivating banks to mitigate their default risk by using capital buffers against adverse effects in portfolio risk. Using a large sample of 126 banks from 9 MENA countries from 2009 to 2014, we study whether support, funding, and risk disclosure motivate banks to hold larger capital buffers to cover potential portfolio risk or not; and whether it affects differently Islamic and conventional banking sectors. Our paper findings provide evidence of the contradictory effects of these factors on Islamic banks compared to conventional banks. While government support results in higher capital buffers, stronger market discipline resulting from uninsured liabilities and disclosure results in larger capital buffers. Most factors look effective only for the conventional banking industry and ineffective for the Islamic banking industry due to its risk-sharing characteristic. Our paper findings provide evidence of the effectiveness of market discipline mechanisms, especially for the conventional banking industry. Moreover, high government support reinforces the disclosure and uninsured funding effects, especially for conventional banks. Finally, competition minimizes bank’s risk incentives.

Managerial risk-taking incentives and cash holding in U.S. firms: Evidence from FAS 123R

Employing FAS 123R, which mandated option expensing, as a quasi-natural experiment, we investigate the causal effects of CEO risk incentives (vega) on cash policies of U.S. firms. Employing a difference-in-differences framework with propensity-score matching, we find no association between changes in CEO portfolio vega and corporate cash holdings, including the marginal value of cash. Our finding applies to both firms most and least affected by the regulatory change. Thus, our evidence challenges the view that stock options are a first-order determinant of corporate cash policy, implying that any previously documented relation may reflect endogeneity rather than a causal influence.

Option-Based Risk Incentives, Prior Losses, and Firm Performance

Option-Based Risk Incentives, Prior Losses, and Firm Performance

Executives Risk Incentives, Corporate Liquidity, and the Cost of Bank Loans

Executives Risk Incentives, Corporate Liquidity, and the Cost of Bank Loans

Mediating Effects of Accounting Conservatism on The Relationship Between Corporate Governance and Cost of Capital

Mediating Effects of Accounting Conservatism on The Relationship Between Corporate Governance and Cost of Capital

Unraveling the complexity of human behavior and urbanization on community vulnerability to floods

Floods are among the costliest natural hazards and their consequences are expected to increase further in the future due to urbanization in flood-prone areas. It is essential that policymakers understand the factors governing the dynamics of urbanization to adopt proper disaster risk reduction techniques. Peoples’ relocation preferences and their perception of flood risk (collectively called human behavior) are among the most important factors that influence urbanization in flood-prone areas. Current studies focusing on flood risk assessment do not consider the effect of human behavior on urbanization and how it may change the nature of the risk. Moreover, flood mitigation policies are implemented without considering the role of human behavior and how the community will cope with measures such as buyout, land acquisition, and relocation that are often adopted to minimize development in flood-prone regions. Therefore, such policies may either be resisted by the community or result in severe socioeconomic consequences. In this study, we present a new Agent-Based Model (ABM) to investigate the complex interaction between human behavior and urbanization and its role in creating future communities vulnerable to flood events. We identify critical factors in the decisions of households to locate or relocate and adopt policies compatible with human behavior. The results show that when people are informed about the flood risk and proper incentives are provided, the demand for housing within 500-year floodplain may be reduced as much as 15% by 2040 for the case study considered. On the contrary, if people are not informed of the risk, 29% of the housing choices will reside in floodplains. The analyses also demonstrate that neighborhood quality—influenced by accessibility to highways, education facilities, the city center, water bodies, and green spaces, respectively—is the most influential factor in peoples’ decisions on where to locate. These results provide new insights that may be used to assist city planners and stakeholders in examining tradeoffs between costs and benefits of future land development in achieving sustainable and resilient cities.