Seeking Alpha: Excess Risk Taking and Competition for Managerial Talent

We present a model where firms compete for scarce managerial talent (“alpha”) and managers are risk-averse. When managers cannot move across firms after being hired, employers learn about their talent, allocate them efficiently to projects and provide insurance to low-quality managers. When instead managers can move across firms, firm-level coinsurance is no longer feasible, but managers may self-insure by switching employer to delay the revelation of their true quality. However this results in inefficient project assignment, with lowquality managers handling projects that are too risky for them. (JEL D62, G32, G38, J33) Send correspondence to Paolo Volpin, Cass Business School, City University London, 106 Bunhill Row, London, EC1Y 8TZ, UK; telephone: +44 (0) 2070400961. E-mail: Paolo.Volpin. 1@city.ac. uk. Ulf Axelson, Marco Battaglini, Philip Bond, Mike Burkart, Adolfo de Motta, David Dicks, Itay Goldstein (editor), Michael Fishman, Hendrik Hakesen, Hugo Hopenhayn, Jack Shim, Giancarlo Spagnolo, two anonymous referees, and participants in the 2010 AEA Meetings, 2012 AFA Meetings, the Third Conference on Financial Integration and Stability in Mannheim, 2010 EFA Meetings, 2010 Mitsui Conference at University of Michigan, the 2011 WFA Meetings, the 2011 ESSET in Gerzensee, the 2012 CSEF-IGIER Symposium on Economics and Institutions, the 2013 Econometric Society Meetings in San Diego, and in seminars at Arizona State University, Bocconi University, Boston College, INSEAD, New York University provided useful comments and discussions. We acknowledge financial support from the Fondation Banque de France, ERC (FINLAB project no. 295709), Europlace Institute of Finance, Inquire Europe, and BNP Paribas Hedge Fund Center (HEC Paris). In the last few decades, the financial sector, and particularly investment banking, has featured increasing competition for managerial talent. As argued by Morrison and Wilhelm (2008), this development occurred in investment banking since the increased importance of economies of scale associated with new technologies made the partnership model obsolete, and induced investment banks to turn into corporate entities and go public. While partnerships encouraged close relationships between employees and posed a natural obstacle to their mobility, the greater transparency of corporations facilitated the poaching of star employees and decreased their corporate loyalty. This development also occurred in commercial banking, which once entailed a great deal of local knowledge, so that over their careers bank managers developed employerand location-specific skills; today banking is much less local, owing to the increasing role of large banks, greater distance between banks and customers, and reliance on hard rather than soft information in lending (Petersen and Rajan, 2002, and Berger, et al, 2005). In fact, an increase in managerial mobility occurred even beyond the boundaries of the financial industry, as witnessed by the historical trend towards outside CEO appointments (Huson, Parrino and Starks, 2001): in 1940-67, 70 percent of top U.S. executives worked for the same company throughout their careers, while in 1990-2003 their fraction was only 30 percent of the total (Frydman, 2007). Most of the academic and media attention has focused on the spectacular growth of financial managers’ pay associated with this increase in the competition for their talent, and on the resulting increase in income inequality (Philippon and Reshef, 2012, and Bell and van Reenen, 2013). In this paper, we argue that, beside its effect on income distribution, competition for managerial talent may also lead to misallocation of talent by hampering employers’ ability to learn the true skills of As argued by Smith (2009), “in time there was significant erosion of the simple principles of the partnership days. [. ] Competition for talent made recruitment and retention more difficult and thus tilted negotiating power further in favor of stars. [. ] You had to pay everyone well because you never knew what next year would bring, and because there was always someone trying to poach your best trained people, whom you didn’t want to lose even if they were not superstars. Consequently, bonuses in general became more automatic and less tied to superior performance. ”