Managerial Incentives , Derivatives and Stability By Kose

In this paper we model the derivative strategies optimally undertaken by a manager (or head of a profit center in a hedge fund) when the detailed derivative positions taken are not contractible. We show that the commonly-used incentive features in the compensation structure of topmanagement in firms or hedge-fund managers may induce them to implement complex derivative strategies that lead to the following pay-off pattern: a high probability (close to one) of a slight increase in performance measures at the cost of allowing for the possibility of disaster states involving large losses, although with a very small probability. These disaster states cause systemic instability (similar to the experience of Long-Term Capital Management in September 1998). We discuss possible audit strategies, governance mechanisms and incentive structures that will ameliorate the probability of systemic instability arising from such incentives in a market with a rich enough menu of derivatives. We characterize the optimal intensity of audit effort with and without the presence of such derivative strategies. The dependence of the optimal audit intensity on the legal liability regime and different rules for apportioning the auditor’s liability is derived. Our results also relate the optimal audit intensity to the cost and efficiency parameters of the audit firm. Current Draft: October 2004 ___________________ Please address comments to Kose John (kjohn@stern.nyu.edu) or Teresa A. John (tjohn@stern.nyu.edu), Stern School of Business, New York University, 44 West 4 Street, New York, N.Y. 10012. Financial support from a New York University summer research grant is gratefully acknowledged. Preliminary Draft. Please do not quote or circulate without the authors’ permission. 1 See, e.g., Litzenberger (1992), Group of Thirty (1993), Wharton Survey (1995), and Phillips (1995). 2 See, for example, Bookstaber(1990), Edwards (1981), Froot, Scharfstein and Stein (1993), Nance, Smith and Smithson (1993) and Smith and Stulz (1985). Managerial Incentives, Derivatives and Stability Since the 1980's, the derivative markets experienced substantial growth both in terms of the volume of transaction and the types of instruments available. (As of year-end 1994, well over 70% of the U.S. Fortune 500 firms reported using derivative instruments.) These derivative instruments enable the firm to hedge, speculate, and in other ways modify the distribution of cash flows significantly at relatively low cost . On one hand, the availability of these new markets and instruments has made it possible for the firms to hedge specific risks (for example, commodity price, exchange rate and interest rate risks) at low transactions costs. On the other hand, the possibility of modifying the probability distribution of cash flows of the firm in specific custom-made ways at low cost opens up some important incentive problems. For example, the manager of ahedge fund,or the CEO of a firm, compensated by a conventional performance-based compensation contract, can modify the probability distribution of the cash flows of his profit center to “game” very closely his compensation contract. A bank, which is subject to regulatory supervision, can modify its cash flow structure to specifically “game” the rules of the particular regulatory regime in place. Although the presence of these incentive problems is not a new phenomenon, we will argue that the low-cost customization of probability distributions using complex derivative positions has made it possible to implement strategies specifically designed to “game” These strategies constitute a general version of the risk-shifting strategies implemented by the manager of a limited-liability corporation with risky debt outstanding, when his compensation aligns him with equity holders, and there is incomplete contracting vis-a-vis the riskiness of investment choices. See, e.g., John and John (1993), and John, John, and Senbet (1991), and John(1987). 2 compensation structures in place, at the same time evading detection by conventional audit mechanisms. There are countless strategies which can be implemented to “game” compensation structures and regulatory regimes in place, using derivatives. (See, e.g., Bookstaber (1990). ) The detailed positions in the different instruments and the resulting pay-off structures will be discussed later. However, a simple characterization of the generic strategy which can be implemented by a profit center in a manufacturing firm or a financial institution is as follows: hold appropriate derivative positions to synthesize an incremental cash flow distribution such that with 99.99% probability, it adds in a modest way to its earnings from the underlying activity, but with . 01% probability, it causes large losses. The relative size of the modest increase and the large losses can be chosen such that the above strategy is a self-financing one. Moreover, since the large-loss state may not “occur” for a number of periods, the profit center can show superior performance for a number of periods prior to the realization of the large-loss outcome. The use of derivatives to customize cash flow distributions in order to game incentive structures and regulatory regimes raises several auditing and monitoring issues: (a) For the top management of a manufacturing firm or a financial institution, a crucial challenge may be to set up and implement optimal internal audit systems and procedures to ensure that a particular profit center within the organization does not synthesize and maintain The explosive growth of the volume of transactions and menu of derivative products in the last fifteen years and some recent highly publicized derivative losses (e.g., Proctor and Gamble) have fueled debate on the advisability of regulatory monitoring of the use of these instruments. The counterargument has been that firms can monitor their own derivative use without regulatory intervention. However such an argument rests crucially on the effectiveness and viability of internal and external audit systems even in the presence of complex derivative pay-offs masking the nature of the cash flow distribution of the normal business activity. Aspects of the design of such auditing systems is the focus of this paper. 3 derivative positions which expose the firm to large losses (albeit with a small probability). See Alderman and Tabor (1989). (b) For the regulator or a bank examiner the central question may be the use of optimal monitoring and audit systems such that (i) the bank does not expose the depositors to the large-loss scenario (even with a small probability), (ii) the true-risk of the cum-derivative portfolio of the bank assets can be determined for regulatory purposes, e.g., for charging the appropriate FDIC premiums and undertaking the appropriate level of routine monitoring and corrective actions. (c) From the point of view of an auditing firm which will be exposed to a large legal liability in the large-loss state when it happens, the impact of derivative usage should be incorporated in the design of the optimal procedures for auditing. The analysis in this paper will take the perspective of an audit firm designing its optimal audit strategy. The client firm is levered and the cash flow from its operations is random. Its current level of debt and its random cash flows from operations endow the firm with a certain probability of default. This client firm may be simply hedging using derivatives or implementing the following “complex derivative strategy. ” The strategy is to hold a self-financing portfolio of derivatives such that the sum of the returns from the