earnings management the shapes of the frequency distributions of earnings metrics are not evidence ipso facto we provide evidence that the shapes particularly around zero of the frequency distributions of earnings metrics examined in the extant earnings management literature are affected by 1 deflation using for example price or market capitalization 2 sample selection criteria that lead to differential inclusion exclusion of observations to the left of zero versus observations to the right of zero implicit in studies focusing on firms followed by i b e s and explicit in studies partitioning on a variable differing between loss observations and profit observations 3 differences between the characteristics of observations to the left of zero and observations to the right of zero such as market pricing and analyst optimism pessimism or 4 a combination of these factors since the shapes of the frequency distributions of earnings metrics at zero are likely due to one of the above effects we conclude that the shapes cannot be used as ipso facto evidence of earnings management

bank incentives economic specialization and financial crises in emerging economies abstract we model the vulnerability of an economy to a financial crisis as arising from the interaction of the degree of economic specialization and bank debt financing the probability of a financial crisis is shown to increase in the degree of economic specialization bank debt financing has the beneficial effect of lowering the degree of economic specialization by increasing access to financing of investment opportunities that would not have been financed due to wealth constraints of entrepreneurs financial access effect however bank debt financing induces risk shifting incentives leverage effect the net effect on the probability of a financial crisis depends on which of these two effects dominates we show that commonly employed mechanisms in managing financial crises particularly bailouts induce an additional agency cost by distorting bank incentives to concentrate loans in specific sectors bank debt concentration effect we propose a tax based ex ante solution mechanism that simultaneously induces optimal investment and eliminates the bank debt concentration effect implementation issues and empirical policy implications are also discussed

financial intermediary coalitions abstract in this article an environment in which the investment opportunities of agents are private information is studied and it is shown that financial intermediaries arise endogenously within that environment it is established that financial intermediaries are part of an efficient arrangement in the sense that they are needed to support the authors private information core allocations these intermediaries which are coalitions of agents exhibit the following characteristics in equilibrium they borrow from and lend to large groups of agents they produce information about investment projects and they issue claims that have different state contingent payoffs than claims issued by ultimate borrowers

can agents be better off with pay caps a popular way to discipline the managers of companies or banks that got into trouble during the recent financial crisis has been to impose caps on managers pay using a small extension of the standard principal agent model we argue that pay caps might serve the opposite purpose because the agent might be better off with a pay cap specifically we show that given a fixed effort level to be implemented the agent s expected utility can be decreasing in an upper bound for the agent s reward the effect of pay caps on the general structure of optimal incentive contracts is also characterized while an improvement of contracting information always helps the principal it might increase or decrease the marginal cost of imposing pay caps

the variance gamma v g model for share market returns a new stochastic process termed the variance gamma process is proposed as a model for the uncertainty underlying security prices the unit period distribution is normal conditional on a variance that is distributed as a gamma variate its advantages include long tailedness continuous time specification finite moments of all orders elliptical multivariate unit period distributions and good empirical fit the process is pure jump approximable by a compound poisson process with high jump frequency and low jump magnitudes applications to option pricing show differential effects for options on the money compared to in or out of the money copyright 1990 by the university of chicago

sulfur dioxide control by electric utilities what are the gains from trade title iv of the 1990 clean air act amendments caaa established a market for transferable sulfur dioxide so2 emission allowances among electric utilities this market offers firms facing high marginal abatement costs the opportunity to purchase the right to emit so2 from firms with lower costs and this is expected to yield cost savings compared to a command and control approach to environmental regulation this paper uses econometrically estimated marginal abatement cost functions for power plants affected by title iv of the caaa to evaluate the performance of the so2 allowance market specifically we investigate whether the much heralded fall in the cost of abating so2 compared to original estimates can be attributed to allowance trading we demonstrate that for plants that use low sulfur coal to reduce so2 emissions technical change and the fall in prices of low sulfur coal have lowered marginal abatement cost curves by over 50 percent since 1985 the flexibility to take advantage of these chan

optimal design of pro conservation incentives abstract payments for environmental services pes schemes have become an increasingly accepted and popular mode for governmental and non governmental agencies to use in addressing local and regional declines in ecosystem services in pes schemes payments can either be tied to indicators of actions for service provision or to indicators of the generated service itself performance payments are synonymous for this second group i e payments are completely contingent on the procurement of an environmental good or service such a focus raises several practical issues during implementation we review and translate key aspects of the economic theory of incentives into the context of performance payment schemes with special attention paid to two practical issues risks outside the individual s control and distortion in the measurement of environmental services four different incentive payment approaches are presented and the effects of risk and distortion on optimal incentives are discussed the investigation of each payment approach is accompanied by a discussion of examples from the field

why do bank runs look like panic a new explanation this paper demonstrates that even if depositors are fully rational and always choose the pareto dominant equilibrium when there are multiple equilibria a bank run may still occur when depositors expectations on the bank s fundamentals do not change more specifically a bank run may occur when depositors learn that noisy bank specific information will be revealed or when they learn that precise bank specific information will not be revealed the results in this paper are consistent with the empirical evidence about bank runs it also implies that suspension of convertibility can improve the efficiency of bank runs

legislative systems with absolute party discipline implications for the agency theory approach to the constituent legislator link this paper examines how the presence of absolute party discipline forces one to re examine some of the issues surrounding the constituent legislator link with absolute party discipline slack at the individual district level is determined by the policy choices of a political party rather than by the choices of the individual legislator this party discipline not only has implications for the representational effectiveness of individual legislators but also results in the terms slack and shirking no longer necessarily being synonymous the empirical work shows that canadian political parties engaged in wide scale shirking on the 1988 u s canada free trade agreement

capture and ideology in the economic theory of politics the economic theory of regulation long ago put public interest theories of politics to rest these theories have correctly been viewed as normative wishings rather than explanations of real world phenomena they have been replaced by models of political behavior that are consistent with the rest of microeconomics anthony downs 1957 james buchanan and gordon tullock 1965 george stigler 1971 sam peltzman 1976 recently however debate has arisen over whether some version of a public interest theory of regulation will have to be readmitted to our thinking about actions and results in the political arena what is at issue is the empirical importance of the altruistic publicly interested goals of rational actors in determining legislative and regulatory outcomes james kau and paul rubin 1979 kalt 1981 peltzman 1982 this study assesses the nature and significance of publicly interested objectives in a particular instance of economic policymaking u s senate voting on coal strip mining regulations the existence of such objectives is of course no contradiction of the economic view of human behavior kenneth arrow 1972 gary becker 1974 and may well be rooted in genetic biological history becker 1976 jack hirshleifer 1978 generally however individuals altruistic publicly interested goals have been given little attention this reflects the judgment that such goals are so empirically unimportant as to allow the use of occam s razor in positive models or well founded apprehensions that these goals are unusually difficult to identify measure and analyze notwithstanding the latter problem we find that approaches which confine themselves to a view of political actors as narrowly egocentric maximizers explain and predict legislative outcomes poorly the tracking and dissecting of the determinants of voting on coal strip mining policy suggest that the economic theory of politics has been prematurely closed to a broader conception of political behavior

the design of securities abstract this paper investigates the determinants of security design we consider the assignment of both cash flows and voting rights focusing on corporate control we postulate that a conflict of interest exists between contestants for control and outside investors the conflict arises because private benefits of control give contestants an incentive to acquire control even when this reduces firm value security design is a tool for resolving these conflicts and maximizing firm value our main result is that a single voting security is optimal

constituent interest vs legislator ideology the role of political opportunity cost this paper applies the economic model of legislative voting to the automobile industry domestic content vote in the u s house of representatives in 1982 we consider constituent interests for and against the ml and compare the predictive powers of alternative indicators of ideological preferences we also examine the role of political opportunity cost and find that lame ducks were significantly less likely to vote for the bill than were returnees to congress given the political advantages of voting for the bill this is consistent with the view that legislators were influenced by the case for freer trade

risk shifting incentives of depository institutions a new perspective on federal deposit insurance reform abstract we characterize the risk shifting incentives of a depository institution as arising fundamentally from the existence of limited liability and the associated convex payoff to equity holders this risk incentive feature is unchanged by deposits being insured and hence excessive risk taking by depository institutions is not solely attributable to the flat rate insurance premium consequently the incentive problem cannot be resolved through a risk based insurance premium contrary to the prevailing view we propose a solution that eliminates risk shifting through an optimal tax structure and specify a corresponding insurance premium that is revenue neutral from the social planner s regulator s standpoint the solution is derived in the context of a social objective function that trades off the benefits of liquidity services by banks and the unique informational role of bank loans with the costs of investment distortions engendered by risk shifting

explanations of protectionism in international trade votes in this study we analyze the voting records of u s senators on three recent international trade bills our objective is to assess the importance of ideology and constituent interest as forces that influence protectionist vs free trade voting behavior the methodology uses discriminant analysis supplemented with expert judgement the first conclusion is that ideology is the more important force in generic protectionism issues and local constituent interests are more important for commodity specific issues second we find that protectionism is especially associated with liberal ideology high import impact and low export dependence although the discriminant analysis outperforms expert judgement in classifying protectionist vs free trade votes in two of the three bills studied the best explanation is obtained by using both methods together

an analysis of the use of accounting and market measures of performance in executive compensation contracts prior research has provided useful insights into the structure of compensation plans and their incentive effects however one important limitation of these studies is the virtual absence of any cross sectional analyses of the attributes of compensation contracts 2 this absence is related in part to the problems associated with controlling for other factors that affect compensation that is compensation contracts are

leverage decision and manager compensation with choice of effort and volatility abstract we study the incentive effects of granting levered or unlevered stock to a risk averse manager the stock is granted by risk neutral shareholders who choose leverage and compensation level the manager applies costly effort and selects the level of volatility both of which affect expected return the results are driven by the attempt of the risk neutral shareholders to maximize the value of their claims net of the compensation package we consider a dynamic setting and find that levered stock is optimal for high type managers firms with high momentum large firms and firms for which additional volatility only implies a modest increase in expected return

information reliability and a theory of financial intermediation this paper is an analysis of when it will be beneficial for agents engaged in the production of information to form coalitions the model is cast in a financial market framework thus leading to an identification of conditions sufficient for the existence of financial intermediaries intermediation is shown to improve welfare if informational asymmetries are present and the information generated to rectify these asymmetries is potentially unreliable the usual appeal to transactions costs to explain intermediation is not needed

optimal incentive contracts in the presence of career concerns theory and evidence this paper studies optimal incentive contracts when workers have career concerns concerns about the effects of current performance on future compensation we show that the optimal compensation contract optimizes total incentives the combination of the implicit incentives from career concerns and the explicit incentives from the compensation contract thus the explicit incentives from the optimal compensation contract should be strongest for workers close to retirement because career concerns are weakest for these workers we find empirical support for this prediction in the relation between chief executive compensation and stock market performance

explaining house voting on the north american free trade agreement this paper analyzes representatives voting patterns on nafta the public choice model posits that representatives vote to redistribute wealth to constituents evidence presented here indicates that the heckscher ohlin model is appropriate to represent the redistributional effects of nafta using a three factor variant of the heckscher ohlin model evidence is presented indicating that representatives voted to redistribute wealth to their geographical and electoral constituents the ability of geographically concentrated interests and of special interests to influence representatives votes helps to explain the weak party allegiance demonstrated on the nafta vote

optimal financial crises empirical evidence suggests that banking panics are related to the business cycle and are not simply the result of sunspots panics occur when depositors perceive that the returns on bank assets are going to be unusually low we develop a simple model of this in this setting bank runs can be first best efficient they allow efficient risk sharing between early and late withdrawing depositors and they allow banks to hold efficient portfolios however if costly runs or markets for risky assets are introduced central bank intervention of the right kind can lead to a pareto improvement in welfare from the earliest times banks have been plagued by the problem of bank runs in which many or all of the bank s depositors attempt to withdraw their funds simultaneously because banks issue liquid liabilities in the form of deposit contracts but invest in illiquid assets in the form of loans they are vulnerable to runs that can lead to closure and liquidation a financial crisis or banking panic occurs when depositors at many or all of the banks in a region or a country attempt to withdraw their funds simultaneously prior to the twentieth century banking panics occurred frequently in europe and the united states panics were generally regarded as a bad thing and the development of central banks to eliminate panics and ensure financial stability has been an important feature of the history of financial systems it has been a long and involved process the first cerntral bank the bank of sweden was established more than 300 years ago the bank of england played an especially important role in the development of effective stabilization policies in the eighteenth and nineteenth centuries by the end of the nineteenth century banking panics had been eliminated in europe the last true panic in england was the overend gurney company crisis of 1866

the effect of lender identity on a borrowing firm s equity return previous research demonstrates that a firm s common stock price tends to fall when it issues new public securities by contrast commercial bank loans elicit significantly positive borrower returns this article investigates whether the lender s identity influences the market s reaction to a loan announcement although we find no significant difference between the market s response to bank and nonbank loans we do find that lenders with a higher credit rating are associated with larger abnormal borrower returns this evidence complements earlier findings that an auditor s or investment banker s perceived quality signals valuable information about firm value to uninformed market investors previous studies show that certain types of loan announcements generate significantly positive abnormal returns to the average borrower s equity 1 this finding contrasts with the negative equity returns generally associated with a corporation s issuance of public securities smith 1986 this difference in market reactions indicates that private and public securities are not perfect substitutes for the average firm in this sense lender identity defined as public versus private lender significantly impacts the borrower s abnormal equity return the standard theoretical explanation for this difference is that private lenders either obtain private information about the firm s value or they have the incentive and ability to monitor firm behavior more effectively than other outside monitors can although the empirical literature on private lending has evaluated primarily commercial bank loans and lines of credit these theoretical arguments apply equally to any type of private

financial intermediaries and liquidity creation trading losses associated with information asymmetries can be mitigated by designing securities which split the cash flows of underlying assets these securities which can arise endogenously have values that do not depend on the information known only to informed agents bank debt deposits is an example of this type of liquid security which protect relatively uninformed agents and we provide a rationale for deposit insurance in this content high grade corporate debt and government bonds are other examples implying that a money market mutual fund based payments system may be an alternative to one based on insured bank deposits

justifying the first order approach to principal agent problems it is of interest to know when the incentive compatibility conditio n in principal agent problems can be replaced by the condition that the agent s expected utility be stationary in effort the mirrlees rogerson conditions do not work if the principal can observe more than one observable statistic also the mirrlees rogerson assumption that the distribution function of output is convex in the agent s action is unsatisfactory even in the context of the basi c model it is too restrictive the paper presents a suite of conditio ns that are applicable to the multistatistic case and replaces the objectionable convex distribution function assumption copyright 1988 by the econometric society

the provision of incentives in firms i ncentives are the essence of economics despite many wide ranging claims about their supposed importance there has been little empirical assessment of incentive provision for workers the purpose of this paper is to critically overview existing work on the provision of incentives since the interests of workers and their employers are not always aligned a large theoretical literature has emphasized how firms design compensation contracts to induce employees to operate in the firm s interest this literature has reached into many areas of compensation and has pointed to a multitude of different mechanisms that can be used to induce workers to act in the interests of their employers these include piece rates options discretionary bonuses promotions profit sharing efficiency wages deferred compensation and so on my objective here is to evaluate this literature in the light of a growing empirical literature on compensation where possible i will address the literature from two perspectives first an underlying assumption of this literature is that individuals respond to contracts that reward performance accordingly i consider whether agents behave in this way and whether these responses are always in the firm s interest second i address whether firms write contracts with these responses in mind in other words do contracts look like the predictions of the theory incentives are provided to workers

an equilibrium model of asset pricing and moral hazard this article develops an integrated model of asset pricing and moral hazard it is demonstrated that the expected dollar return of a stock is independent of managerial incentives and idiosyncratic risk but the equilibrium price of the stock depends on them thus the expected rate of return is affected by managerial incentives and idiosyncratic risk it is shown however that managerial incentives and idiosyncratic risk affect the expected rate of return through their influence on systematic risk rather than serve as independent risk factors it is also shown that the risk aversion of the principal in the model leads to less emphasis on relative performance evaluation than

executive compensation and principal agent theory the empirical literature on executive compensation generally fails to specify a model of executive pay on which to base and test hypotheses regarding its determinants in contrast this paper analy

performance thresholds in managerial incentive contracts performance thresholds are commonly used in executive compensation contracts we examine the contractual nonlinearity associated with performance thresholds and its incentive implications incorporating a performance threshold into a standard principal agent model of a linear contract we show that pay schemes using a performance threshold are optimal by truncating a linear scheme at poor performance the threshold mitigates agency costs associated with the downside risk of production examining ceo compensation data we find evidence of the role of performance thresholds as a consequence of under threshold performance the tobit estimator is shown to increase pay performance sensitivity notably improving upon the standard ols estimator

the other side of the trade off the impact of risk on executive compensation the principal agent model of executive compensation is of central importance to the modern theory of the firm and corporate governance yet the exiting empirical evidence supporting it is quite wea

economic interests and voting on the omnibus trade bill of 1987 this paper presents an econometric analysis of the votes on five pivotal amendments to the omnibus foreign trade bills of the u s house and senate in 1987 probit estimation is used to identify the relationships between geographic variations in employment in trade sensitive industries and congressional voting on changes in foreign trade policy procedures the implied pattern of expected net benefits for the industries from the five amendments is highly consistent with qualitative evidence on the costs and benefits at stake two general conclusions stand out 1 procedural foreign trade policy proposals can have very specific beneficiaries 2 diffuse export interests can be influential in opposition to procedural protectionism

the fine structure of asset returns an empirical investigation we investigate the importance of diffusion and jumps in a new model for asset returns in contrast to standard models we allow for jump components displaying finite or infinite activity and variation empirical investigations of time series indicate that index dynamics are devoid of a diffusion component which may be present in the dynamics of individual stocks this leads to the conjecture confirmed on options data that the risk neutral process should be free of a diffusion component we conclude that the statistical and risk neutral processes for equity prices are pure jump processes of infinite activity and finite variation

senate voting patterns on the 1991 extension of the fast track trade procedures prelude to nafta in 1991 then president george bush requested an extension of fast track procedures from congress for the primary purpose of negotiating a north american free trade agreement this paper uses an econometric model to test the importance of three themes related to nafta that surfaced during senate debates over whether to approve the request that of employment effects environmental effects and the impact on immigration from mexico the empirical results show that expected job gains and losses were significant in explaining senate voting patterns on fast track extension immigration was found to be somewhat important but environmental issues were not found to statistically significant in addition the impact of organized labor and political ideology as proxied by political party were found to be important factors that shaped senate voting patterns on fast track

deposit insurance and financial development the authors examine the effect of different design features of deposit insurance on long run financial development defined to include the level of financial activity the stability of the banking sector and the quality of resource allocation their empirical analysis is guided by recent theories of banking regulation that employ an agency framework the authors examine the effect of deposit insurance on the size and volatility of the financial sector in a sample of fifty eight countries they find that generous deposit insurance leads to financial instability in lax regulatory environments but in sound regulatory environments deposit insurance does have the desired impact on financial development and growth thus countries introducing a deposit insurance scheme need to ensure that it is accompanied by a sound regulatory framework otherwise the scheme will likely lead to instability and deter financial development in weak regulatory environments policymakers should at least limit deposit insurance coverage

foreign direct investment and regulatory remedies for banking crises lessons from japan can regulatory interventions alleviate financial crises if so which ones work we draw inferences from the japanese banking crisis of the 1990s using a hand gathered database of bank loans gathered from original sources our results indicate that whereas risk based capital infusions in japan similar to those following the 2009 supervisory capital assessment program stress tests in the us were successful in stimulating aggregate lending by japanese banks earlier blanket infusions comparable to the 2008 troubled asset relief program tarp in the us were not effective moreover changes in accounting rules in japan that revalued bank assets similar to the relaxation of mark to market requirements for banks in the us did not increase aggregate japanese bank lending but rather reallocated it capital constraints during the crisis also induced many japanese banks to close their overseas branches and switch their charters from international to domestic this endogenous charter switch reversed the process of foreign direct investment fdi for many japanese banks therefore we use the japanese banking crisis as a natural experiment to test fdi theories and find empirical support for the relative access hypothesis but not for the industrial organization approach or for the relative wealth hypothesis

why is there so little money in u s politics in this paper we argue that campaign contributions are not a form of policy buying but are rather a form of political participation and consumption we summarize the data on campaign spending and show through our descriptive statistics and our econometric analysis that individuals not special interests are the main source of campaign contributions moreover we demonstrate that campaign giving is a normal good dependent upon income and campaign contributions as a percent of gdp have not risen appreciably in over 100 years if anything they have probably fallen we then show that only one in four studies from the previous literature support the popular notion that contributions buy legislators votes finally we illustrate that when one controls for unobserved constituent and legislator effects there is little relationship between money and legislator votes thus the question is not why there is so little money politics but rather why organized interests give at all we conclude by offering potential answers to this question this abstract was borrowed from another version of this item

under what circumstances past and present have international rescues of countries in financial distress been successful recent events in asia and other parts of the globe have prompted calls from many quarters for international rescue of the monetary or fiscal authorities in distressed countries we contrast the experience of rescues of monetary authorities before 1973 of advanced countries temporarily short of liquidity with recent experience of bailouts international rescues in the past have involved relatively small amounts of money sufficient to stave off devaluation or abandonment of a fixed exchange rate while remedial policies were put in place recent bailouts have involved handing over relatively large amounts to both foreign lenders and domestic investors after devaluation of a pegged exchange rate to avoid their incurring wealth losses we document past rescues whether successful or unsuccessful by monetary regimes and show what is different today from past experience

quota based compensation plans for multiterritory heterogeneous salesforces we compare quota based salesforce compensation plans with the blss plan i e the optimal curvilinear agency theory based compensation plans proposed in basu lal srinivasan and staelin basu a k r lal v srinivasan r staelin 1985 salesforce compensation plans an agency theoretic perspective marketing sci 4 fall 267 291 a quota plan pays a fixed salary which is supplemented by commission income that is a prespecified fraction of the dollar sales that exceed the quota for a salesforce comprised of multiple salespersons territories we consider a basic quota plan where the commission rate and salary remain the same across salespersons however quotas vary across salespersons territories compared to the blss plan that is individually tailored to each salesperson territory the basic quota plan s total nonoptimality in profit has two components i a shapeinduced nonoptimality arising from the fact that the quota based plan does not have the same optimal shape as the curvilinear blss pl

are ceos really paid like bureaucrats a common view is that there is little correlation between firm performance and ceo pay using a new fifteen year panel data set of ceos in the largest publicly traded u s companies we document a strong relationship between firm performance and ceo compensation this relationship is generated almost entirely by changes in the value of ceo holdings of stock and stock options in addition we show that both the level of ceo compensation and the sensitivity of compensation to firm performance have risen dramatically since 1980 largely because of increases in stock option grants

u s banks crises and bailouts from mexico to ltcm this paper investigates the impact on bank stock prices of emerging market currency crises and bailouts the stock market distinguishes between banks with exposure to a crisis country and other banks in general banks with exposures to a crisis country are affected adversely by currency events and positively by bailouts other banks are mostly unaffected by events in countries experiencing a crisis the paper uses the impact of the ltcm crisis on bank stock prices to put the emerging market events in perspective the ltcm crisis had no significant contagion effects in the banking sector either but banks that participated in the ltcm rescue experienced negative stock returns when the rescue was announced this abstract was borrowed from another version of this item

top management compensation and capital structure the interrelationship between top management compensation and the design and mix of external claims issued by a firm is studied the optimal managerial compensation structures depend on not only the agency relationship between shareholders and management but also the conflicts of interests which arise in the other contracting relationships for which the firm serves as a nexus we analyze in detail the optimal management compensation for the cases when the external claims are 1 equity and risky debt and 2 equity and convertible debt in addition to the role of aligning managerial incentives with shareholder interests managerial compensation in a levered firm also serves as a precommitment device to minimize the agency costs of debt the optimal management compensation derived has low pay performance sensitivity with convertible debt instead of straight debt the corresponding optimal managerial compensation has high pay to performance sensitivity a negative relationship between pay performance sensitivity and leverage is derived our results provide a reconciliation of the puzzling evidence of jensen and murphy 1990 with agency theory other testable implications include 1 a relationship between the risk premium in corporate bond yields and top management compensation structures and 2 the announcement effect of adoption of executive stock option plans on bond prices the model yields implications for management compensation in banks and federal deposit insurance reform our results explain the dynamics of top management compensation in firms going through financial distress and reorganization

accounting earnings and top executive compensation abstract this paper investigates the role of accounting earnings in top executive compensation contracts it provides evidence in support of the hypothesis that earnings based incentives help shield executives from market wide factors in stock prices the paper demonstrates that earnings reflect firm specific changes in value but are less sensitive to market wide movements in equity values as a result the inclusion of earnings based performance measures in executive compensation contracts helps shield executives from fluctuations in firm value that are beyond their control the hypothesis is shown to explain cross sectional variation in the use of earnings based incentives

risk aversion performance pay and the principal agent problem this paper calculates numerical solutions to the principal agent problem and compares the results to the stylized facts of ceo compensation the numerical predictions come from parameterizing the models of grossman and hart and of holmstrom and milgrom while the correct incentives for a ceo can greatly enhance a firm s performance providing such incentives need not be expensive for many parameter values ceo compensation need increase only by about 10 for every 1 000 of additional shareholder value for some values the amount is 0 003 cents

lower salaries and no options on the optimal structure of executive pay we estimate a standard principal agent model with constant relative risk aversion and lognormal stock prices for a sample of 598 us ceos the model is widely used in the compensation literature but it predicts that almost all of the ceos in our sample should hold no stock options instead ceos should have lower base salaries and receive additional shares in their companies for a typical value of relative risk aversion almost half of the ceos in our sample would be required to purchase additional stock in their companies from their private savings the model predicts contracts that would reduce average compensation costs by 20 while providing the same incentives and the same utility to ceos we investigate a number of extensions and modi cations of the standard model but nd none of them to be satisfactory we conclude that the standard principal agent model typically used in the literature cannot rationalize observed contracts one reason may be that executive pay contracts are suboptimal

the textile bill of 1985 the determinants of congressional voting patterns the following tables show the results of the probit analysis for the senate and the house a table including results for different combinations of the independent variables is included in an unpublished appendix available from the authors upon request the results of the probit analysis for the senate are shown in table 1 all the variables except exp had the expected signs however the results indicate that the two other employment variables and party affiliation are the only factors which we can say with confidence influenced a senator s decision to vote for or against this bill the coefficients reported and labeled der of prob measure the derivative of the probability of a yes vote evaluated at the means of the independent variables in question thus for example the coefficient for unemp in the top line of table 1 should be interpreted as indicating that a one percentage point increase in a state s unemployment rate will cause a 5 89 increase in the probability that the senator will vote for the bill the result for dr the party of the senator shows that in general democrats are more apt to vote for protectionist policies than are republicans this is consistant with president reagan s negative stand on the bill and his threat to veto it should it pass the amendment in question passed the senate on 24 october 1985 by a vote of 54 for to 42 against but the bill it was attached to has been postponed indefinitely the house bill which was passed on 10 october 1985 by a vote of 262 for to 159 against was vetoed by reagan on 17 december 1985 the results of the probit analysis for the house of representatives are shown in table 2 state employment data was used for the house as opposed to data for each voting district this was done for three reasons first employment data is usually reported by state or by county since counties are often divided by congressional district boundaries much personal judgement would be necessary to assign employment figures second the most recent county industry employment data is from 1981 while the data used in this analysis is from 1984 third we feel that in general logrolling is prevalent among a state s representatives for this bill the representatives from twenty six states voted as a block and in all but six states one third or less of that state s representatives voted contrary to the majority all of the probabilities are significant at the 05 confidence level representative s voting patterns are influenced by all of the included factors when unionization is added to the equation its coefficient is very small and negative although it is significant at the 05 confidence level one would expect more significance here since there are more degrees of freedom for the house analysis than for that of the senate when the data from the house and senate are pooled the results are similar to those of the house alone the null hypothesis that the data cannot be pooled was tested using a statistic with eight degrees of freedom 9 721 meaning that the null hypothesis is rejected as in the senate the state unemployment rate and the percent employed in textiles are important influences on the representative s vote and democrats in the house are more likely to vote for protectionist bills than republicans however unlike the senate the percent of a representative s campaign contributions that are donated by industry special interest groups has a significant effect on voting patterns although the point estimates for the magnitudes of the influence are very similar in both cases seventy four percent of the house received campaign contributions from these special interest groups while only 54 of the senate received contributions from these same sources this is probably because only one third of the senate was up for reelection during the time period considered while the entire house was in the process of campaigning for reelection exports also play a role in influencing the probability of a yes vote reducing this probability as employment in export industries increases but the magnitude of the coefficient is only 11 of that for textile employment the significance of this variable in the house is probably due to fear of retaliation expressed by both democrats and republicans this variable was not significant in the senate model most likely because the senate version excluded from the 1 import quota growth rate many countries who might have retaliated representatives appear to respond to a wider variety of constituent interests than do senators while senators voting patterns are only significantly influenced by their political affiliation their state s unemployment rate and the importance of textiles to their state the voting behavior of representatives is influenced by these factors as well as the importance of exports to their state and campaign contributions by textile special interest groups these results affirm the validity of the approach used by baldwin and coughlin they differ from baldwin who finds exports are not a significant influence on the house and from coughlin who does not include export employment as an explanitory variable or analyze the differences in voting patterns between the house and the senate

aggregation and linearity in the provision of intertemporal incentives we consider the problem of providing incentives over time for an agent with constant absolute risk aversion the optimal compensation scheme is found to be a linear function of a vector of n accounts which count the number of times that each of the n kinds of observable events occurs the number n is independent of the number of time periods so the accounts may entail substantial aggregation in a continuous time version of the problem the agent controls the drift rate of a vector of accounts that is subject to frequent small random fluctuations the solution is as if the problem were the static one in which the agent controls only the mean of a multivariate normal distribution and the principal is constrained to use a linear compensation rule if the principal can observe only coarser linear aggregates such as revenues costs or profits the optimal compensation scheme is then a linear function of those aggregates the combination of exponential utility normal distributions and linear compensation schemes makes computations and comparative statics easy to do as we illustrate we interpret our linearity results as deriving in part from the richness of the agent s strategy space which makes it possible for the agent to undermine and exploit complicated nonlinear functions of the accounting aggregates

legislators and interest groups how unorganized interests get represented this paper derives a supply price for public policy using a constrained maximization model in the model three sets of agents each have preferences over outcomes organized interest groups offer campaign contributions to improve their own wealth voters offer votes to obtain outcomes closer to their most preferred outcomes and legislators seek both campaign contributions and votes to obtain reelection a given legislator s supply price for policy is shown to depend on the productivity of his effort as determined by committee assignments priority and ability and by the preferences of his unorganized constituency in the home district two extreme assumptions about the effectiveness of campaign spending in eliciting votes are used to illustrate the comparative statics properties of the model the prediction of the model is that interest groups will in general seek out legislators whose voters are indifferent to the policy the interest group seeks thus voters who do have preferences over policy are in effect represented even though they are not organized

linearity with project selection and controllable diffusion rate in continuous time principal agent problems i extend holmstrom and milgrom s model by allowing the agent to control privately or publicly the diffusion rate process and show that the optimal contract is still linear i discuss the conditions under which conflicts over the choice of diffusion rate do and do not arise as an application i examine project selection problems of a firm conflicts between the manager and investors arise because giving the manager too much incentive to work to increase the profit from ongoing operations can induce him to be too conservative in project selection possibly resulting in optimal contracts with low sensitivities

performance standards and optimal incentives abstract this paper analyzes incentive design when agents effort influences an uncertain output governed by a random process with semi heavy tails we find that the second best incentive contract pays an output increasing but bounded fee with a shape resembling performance standard contracts that pay a fixed salary plus a capped bonus in this contract the pay performance sensitivity around the standard increases decreases with the frequency with which performance is measured and with the kurtosis volatility parameter of the performance probability distribution we also find that the optimal maximum bonus increases with volatility but decreases with the kurtosis parameter of the performance distribution

investment incentives debt and warrants abstract this paper models and characterizes investment incentive problems associated with debt financing the decision problem of residual claimants is explicity formulated and their investment policies are characterized the paper also analyzes the use of conversion features and warrants to control distortionary incentives these claims reverse the convex shape of levered equity over the upper range of the firm s earnings and this mitigates the incentive to take risk it is shown that under certain conditions such claims can be constructed to restore net present value maximizing incentives and simultaneously meet the financing requirements of the firm

suspension of payments bank failures and the nonbank public s losses abstract we present evidence on the effects of suspensions of payments from an episode that is close to a controlled experiment for examining those effects in 1861 about 44 of the banks in wisconsin closed 81 of the banks in illinois closed and noteholders suffered substantial losses the historical record suggests that an effective suspension of payments in wisconsin but not in illinois may explain the difference our statistical evidence indicates that the suspension of payments increased the probability of a bank remaining open by about 21 percentage points and decreased noteholders losses by about 14 cents per dollar

introducing convexity into optimal compensation contracts abstract we study when it is appropriate to add a convex component such as stock options to an optimal managerial compensation contract we show that convexity is introduced when managers have moderate levels of relative risk aversion and decreasing absolute risk aversion in addition we study how convexity is affected as the distribution of outcomes becomes more skewed toward low outcomes here we show that while convexity increases when skewness is increased without regard to the effect on mean stock price the opposite effect results when increases in skewness leave the mean stock price unchanged

domestic content legislation house voting and the economic theory of regulation house voting on domestic content legislation provides a rare opportunity to examine the political economy of protectionism with respect to a particular issue rather than by using the traditional interindustry approach the results indicate that a representative s vote in favor of the content legislation and the intensity of the legislator s preferences are positively related to the importance of the auto and steel industries in the representative s district an increasing unemployment rate campaign contributions from labor groups affiliation with democratic party and a liberal ideology despite ideology s statistical significance the results suggest this variable can be disregarded because neither the predictive accuracy nor the explanatory power of the model is improved by its inclusion the estimates also provide insights concerning the impact of changes in the independent variables upon voting patterns

piecewise linear incentive schemes general outlook and stabilization theories and policies of piecewis e linear incentive schemes are studied in a setting of moral hazard and adverse selection the form of the best such function is analyzed particular attention is given to the loss from using piecewise linear schemes relative to optimal schemes as well as the gain from usin g simpler functional forms such as the linear functions the incentive problem is studied under various informational assumptions which allow some calculations of the value of information copyright 1988 by the editors of the scandinavian journal of economics

the dependence of pay performance sensitivity on the size of the firm i analyze the relationship between firm size and the extent to which executive compensation depends on the wealth of the firm s shareholders i use a simple agency model to motivate an econometric model of this relationship estimating this model on chief executive officer ceo compensation data using nonlinear least squares i determine that pay performance sensitivity as defined by jensen and murphy 1990b appears to be approximately inversely proportional to the square root of firm size however measured i also analyze the properties of pay performance sensitivity for teams of executives working for the same firm and show it to have similar properties as ceo pay performance sensitivity

an analysis of the principal agent problem most analyses of the principal agent problem assume that the principal chooses an incentive scheme to maximize expected utility subject to the agent s utility being at a stationary point an important paper of mirrlees has shown that this approach is generally invalid we present an alternative procedure if the agent s preferences over income lotteries are independent of action we show that the optimal way of implementing an action by the agent can be found by solving a convex programming problem we use this to characterize the optimal incentive scheme and to analyze the determinants of the seriousness of an incentive problem

default and renegotiation a dynamic model of debt we analyze the role of debt in persuading an entrepreneur to pay out cash e ows rather than to divertthem in the e rstpartof the paper we study the optimal debt contract specie cally the trade off between the size of the loan and the repayment under the assumption that some debt contract is optimal in the second part we consider a more general class of nondebt contracts and derive sufficient conditions for debt to be optimal among these

tranching in the syndicated loan market around the world loan tranching allows banks to manage risk and facilitate firm financing which may be essential for firms that cannot access investors from stock markets we analyze the determinants and benefits of loan tranching by pooling the tranches of individual loans to create the largest cross country sample of syndicated loans covering more than 150 000 loans from multinational and domestic firms we find that in addition to market deal and borrower characteristics legal and institutional differences impact loan tranching strong creditor protection and efficient debt collection increase the probability of tranching and reduce tranche spreads ultimately promoting firms access to debt we also find evidence that tranching facilitates the financing of multinational firms abroad due to the transfer of legal and cultural institutions to foreign subsidiaries overall our results suggest that tranching plays an important role in reducing a country s financial development gap and promotes firms access to debt

deposit insurance and wealth effects the value of being too big to fail this paper investigates the effect on bank equity values of the comptroller of the currency s announcement that some banks were too big to fail and that for those banks total deposit insurance would be provided using an event study methodology we find positive wealth effects accruing to tbtf banks with corresponding negative effects accruing to non included banks we demonstrate that the magnitude of these effects differed with bank solvency and size we also show that the policy to which the market reacted was that suggested by the wall street journal and not that actually intended by the comptroller the role of deposit insurance has become a topic of increasing debate advocates argue that by removing the incentive to run deposit insurance protects individual financial institutions from instability in the intermediation process thereby providing stability to the financial system as a whole 1 the recent rise in bank failures and the concomitant crises in the s l industry however demonstrate that this stability is not guaranteed moreover critics note that deposit insurance may introduce incentive problems and wealth effects into the financial system both of which can impede the effective functioning of any deposit insurance system these problems have prompted concern about the structure of the current deposit insurance system and have led to numerous proposals regarding its restructuring 2 this paper investigates one aspect of this debate by analyzing the effect on bank equity values of the policy decision to insure completely some banks but not others specifically in september 1984 the comptroller of the currency testified before congress that some banks were simply too big to fail tbtf and that for those banks total deposit insurance would be provided while not explicitly naming the banks the comptroller admitted that this policy would apply to the eleven largest banks using an event study methodology we analyze