Yesterday's Heroes: Compensation and Risk at Financial Firms

• Author: ING‐HAW CHENG,HARRISON HONG,JOSÉ A. SCHEINKMAN
• Date: 01 April 2015
• DOI: http://doi.org/10.1111/jofi.12225
• Published date: 01 April 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 2 •APRIL 2015

Yesterday’s Heroes: Compensation and Risk

at Financial Firms

ING-HAW CHENG, HARRISON HONG, and JOS´

E A. SCHEINKMAN∗

ABSTRACT

Many believe that compensation, misaligned from shareholders’ value due to man-

agerial entrenchment, caused financial firms to take risks before the financial crisis of

2008. We argue that, even in a classical principal-agent setting without entrenchment

and with exogenous firm risk, riskier firms may offer higher total pay as compensation

for the extra risk in equity stakes borne by risk-averse managers. Using long lags of

stock price risk to capture exogenous firm risk, we confirm our conjecture and show

that riskier firms are also more productive and more likely to be held by institutional

investors, who are most able to influence compensation.

MANY BLAME WALL STREET COMPENSATION for the most significant economic

crisis since the Great Depression. For instance, in his testimony to Congress

on the Treasury budget on June 9, 2009, Treasury Secretary Geithner

argues, “I think, although many things caused this crisis, what happened to

compensation and the incentives that created risk taking did contribute in

some institutions to the kind of vulnerability we saw in this financial crisis”

(emphasis added)1. As a result, U.S. policy makers have promoted reforms

to tie pay to long-term performance and increase the say of shareholders in

approving compensation and electing directors on compensation committees.

The view that incentive misalignment contributed to the crisis is shared by

many other governments as well.2

∗Cheng is at the Tuck School of Business, Dartmouth College. Hong is at Princeton University.

Scheinkman is at Columbia University and Princeton University.This paper subsumes a previous

version titled “Yesterday’s Heroes: Compensation and Creative Risk-Taking.” We thank the Edi-

tor (Campbell Harvey), an anonymous referee, Jeremy Stein, Ren´

e Stulz, Luigi Zingales, Steven

Kaplan, Tobias Adrian, Sule Alan, Augustin Landier, Terry Walter, Bob DeYoung, Ira Kay,

Yaniv Grinstein, Patrick Bolton, Marco Becht, Scott Schaefer, and participants at the Princeton-

Cambridge Conference, SIFR Conference, HEC, NBER, University of Michigan, University of Tech-

nology at Sydney,Chinese University of Hong Kong, CEMFI, LSE, University of Kansas Southwind

Conference, Federal Reserve Bank of New York,Columbia University, ECGI–CEPR–IESE Madrid

Conference, University of Florida, 2011 AFA Meetings, Federal Reserve Bank of Chicago 47th

Annual Conference on Banking, NBER Conference on Market Institutions and Financial Market

Risk, and Georgia State CEAR conference for helpful comments.

1Statement of Treasury Secretary Geithner to the Senate Subcommittee of the Commttiee on

Appropriations, 111th Congress. “Financial Services and General Government Appropriations for

Fiscal Year 2010,” 16-17. U.S. Government Printing Office, Washington, DC.

2For example, in the United Kingdom, a parliamentary committee investigating the crisis

“found that bonus-driven remuneration structures encouraged reckless and excessive risk-taking

DOI: 10.1111/jofi.12225

839

840 The Journal of Finance R

According to this narrative, pay, misaligned from long-term shareholder

value because of managerial entrenchment, caused risk-taking. Firms like Bear

Stearns, Merrill Lynch, and AIG with poorer governance and more misaligned

pay packages than other firms ended up taking excessive risks with disastrous

consequences. Thus, increasing shareholder rights and reforming the distorted

incentives by clawing back pay to tie it to long-term firm performance will

lead to less of this behavior. Anecdotes on the behavior of Bear Stearns and

Lehman Brothers’ CEOs lend some credence to this view. Academic research

also provides support for managerial entrenchment and short-termism as po-

tentially important factors in corporate behavior (see Becht, Bolton and R¨

oell

(2003) and Stein (2003) for reviews). This research, however, typically focuses

on nonfinance firms and predates the financial crisis. There is also very little

direct evidence for this entrenchment perspective among finance firms.

Given the importance of this issue, we believe it important to examine an

alternative, nonentrenchment perspective on the relationship between pay and

risk among financial firms. We show that a strong relationship between pay

and risk can also emerge naturally in a classical principal-agent setting (as

in, for example, Holmstrom and Milgrom (1987) and Holmstrom (1979)) in

which investors optimally set incentive contracts, entrenchment is absent, and

where firm or project risk is taken as exogenous and out of the manager’s

control. There is anecdotal evidence, which we confirm in our analysis below,

that savvy institutional investors such as Bill Miller of Legg Mason, one of

the largest mutual fund companies in the United States, overweighted and

supported the most risky companies like Bear Stearns in their portfolios.3Such

institutional investors with large blocks of shares of a company have typically

been viewed in the literature as having more power to act like a principal

that shapes and incentivizes its agent’s effort and as less subject to behavioral

biases than individual investors. Entertaining a classical setup thus seems to

be a reasonable exercise ex ante.

Under our narrative, pay and risk are correlated not because misaligned

pay leads to risk-taking, but rather because principal-agent theory predicts

that riskier firms have to pay more total compensation than less risky firms

to provide a risk-averse manager the same incentives. To induce a manager to

exert effort and maximize firm value, the principal must provide that manager

incentives or an ownership stake in the firm. For the same level of incentives

or ownership stake, the manager at a riskier firm faces much more wealth

uncertainty because her firm’s stock price is more volatile. Since the manager

is risk-averse, she prefers a less risky firm all else equal, unless of course she

is compensated for bearing the additional risk that comes from working for a

riskier firm. As such, to give the risk-averse manager the same incentives, a

riskier firm has to pay more total compensation than a firm that is less risky.

and that the design of bonus schemes was not aligned with the interests of shareholders and the

long-term sustainability of the banks.” (UK House of Commons (2009)).

3Lauricella, Tom, 2008, The stock picker’s defeat, Wall Street Journal, December 10,

http://online.wsj.com/article/SB122886123425292617.html (last accessed: September 2013).

Yesterday’s Heroes 841

Of course, if it is more expensive for riskier firms to align managerial in-

centives using insider ownership stakes, then, all else equal, these firms may

optimally not want to give as big an insider ownership stake as less risky firms.

In practice, however, there are several reasons, which we elaborate on below,

why even very risky financial firms would want their managers to have own-

ership stakes as large as those of managers of less risky firms. One important

reason is that these firms rely on people with specialized skills (such as man-

aging complex portfolios) and who wield significant influence over outcomes.

When an agent has significant influence over outcomes, it is optimal to keep

her working hard through strong incentives, as the gains to doing so offset the

cost of paying her more. There is plenty of anecdotal evidence that agents work

hard at risky firms; investment banking jobs in particular have a reputation

for long hours and difficult work conditions (Oyer (2008)).

We test this hypothesis using data on executive compensation and risk for

finance firms from 1992 to 2008. We begin by establishing that there is sub-

stantial cross-sectional heterogeneity in residual compensation, which is de-

fined as the total pay of top-five managers controlling for firm size and finance

subindustry effects, where the subindustries are primary dealers, bank holding

companies, and insurance companies. We adjust pay by these two factors as it

is well known that pay scales with size (Gabaix and Landier (2008)), and, as we

show below,compensation varies considerably across the finance subindustries.

We find that residual compensation is highly persistent over time, suggesting

the presence of a firm fixed effect in pay levels. Firms with persistently high

residual compensation include Bear Stearns, Lehman Brothers, Countrywide,

and AIG. Low or moderate residual compensation firms include firms such as

Wells Fargo and Berkshire Hathaway.

We next establish that risk, measured either with a lag or in the year of its

origin (the year the firm first had an IPO or was newly listed), significantly

explains the cross-sectional variation in contemporaneous risk. In other words,

there are also fixed differences in the riskiness of finance firms. In addition

to stock return volatility, we use a firm’s stock market beta to capture the

heterogeneous risk profiles of financial firms. For instance, a firm’s propensity

to sell out-of-the-money puts or insurance on the stock market (i.e., to engage

in tail risk) may not be entirely captured by stock return volatility. Ex post

stock market betas in this instance may better gauge a firm engaging in tail

risk since the firm is fine when the market does well and goes bust when the

market does poorly.

We use lagged firm risk, as well as its origin risk, to capture the exogenous

and permanent component of firm risk.4The thought experiment is one in

which we compare the time tcompensation of firms born with high risk with

the time tcompensation of firms born with low risk, holding size and industry

constant. Importantly, we show that lagged or origin firm risk explains little

4Graham, Li, and Qiu (2012) also find large firm fixed effects for managerial compensation as

well as manager fixed effects. Our analysis here on firm origin volatility helps us further isolate

the role of firm fixed effects as opposed to manager effects on pay.