Wednesday, October 14, 2009

Reducing Incentives for Risk-Taking - DealBook Blog -

Shareholders are the most important party in the nexus of contracts largely because as residucal claimants they are in the best position to monitor the firm. So it is generally well accepted that managers should manage to maximize shareholder wealth. But to what extent does this mean executives can totally forget about other stakeholders.

In the traditional view, if executives do not "take care" of other stakeholders, the managers will eventually be punished by market forces. (for instance if management takes excessive risks and can not pay back depositors, your shareholders would lose and take out their anger on the management by demanding their dismissal.)

But the pendulum swings back and forth and the debate as to what level managers should be compelled to worry about other stakeholders is never clear cut.

In the NY Times, Lucian Bebcuck and Holger Spamann advocate on behalf of other stakeholders to a degree in this thought-provoking article.

Reducing Incentives for Risk-Taking - DealBook Blog -
"Equity-based awards, coupled with the capital structure of banks, tie executives’ compensation to a highly levered bet on the value of banks’ assets. Bank executives expect to share in any gains that might flow to common shareholders, but they are insulated from losses that the realization of risks could impose on preferred shareholders, bondholders, depositors or the government as a guarantor of deposits. This gives executives incentives to give insufficient weight to the possibility of large losses and therefore provides them with incentives to take excessive risks.

How could pay arrangements be redesigned to address this distortion? To the extent that executive pay is tied to the value of specified securities, such pay could be tied to a broader basket of securities, not only common shares."

No comments: