The Masquerade Ball of the CEOs and the Mask of Excessive Risk

Citci, Haluk and Inci, Eren (2012): The Masquerade Ball of the CEOs and the Mask of Excessive Risk.

Abstract

We analyze the effects of CEOs' layoff risk on their risk choice while overseeing a firm. A CEO, whose managerial ability is unknown, is fired if her expected ability is below average. Her risk choice changes the informativeness of output and market's belief about her ability. She can decrease her layoff risk by taking excessive risk and trade off current compensation for layoff risk. The firm may voluntarily or involuntarily allow excessive risk taking even under optimal linear compensation contracts. Above-average CEOs always keep their jobs, but among below-average CEOs, a higher-ability one is more likely to be fired.

• Item Type: MPRA Paper
• Language: English
• Keywords: career concern; CEO turnover; excessive risk taking; managerial conservatism; reputation
• Subjects: L - Industrial Organization > L2 - Firm Objectives, Organization, and Behavior > L21 - Business Objectives of the Firm; G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy ; Financial Risk and Risk Management ; Capital and Ownership Structure ; Value of Firms ; Goodwill; D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D82 - Asymmetric and Private Information ; Mechanism Design; M - Business Administration and Business Economics ; Marketing ; Accounting ; Personnel Economics > M1 - Business Administration > M12 - Personnel Management ; Executives; Executive Compensation; J - Labor and Demographic Economics > J3 - Wages, Compensation, and Labor Costs > J33 - Compensation Packages ; Payment Methods

References

Artzner, Philippe, Freddy Delbaen, Jean-Marc Eber, and David Heath, "Coherent Measures of Risk," Mathematical Finance, 9 (1999): 203-228.

Avery, Christopher N., and Judith A. Chevalier, "Herding over the Career," Economics Letters, 53 (1999), 327-333.

Bebchuk, Lucian A., and Holger Spamann, "Regulating Bankers' Pay," Georgetown Law Journal, 98 (2010), 247-287.

Berger, Philip G., Eli Ofek, and David L. Yermack, "Managerial Entrenchment and Capital Structure Decisions," Journal of Finance, 52 (1997), 1411-38.

Bertrand, Marianne, and Antoinette Schoar, "The managing with style: The Effect of Managers on Corporate Policy," Quarterly Journal of Economics, 118 (2003), 1169-1208.

Blinder, Alan, "Crazy Compensation and the Crisis," The Wall Street Journal, May 28, 2009, p. A15.

Bloom, Matthew C., and George T. Milkovich, "Relationships among Risk, Incentive Pay and Organizational Performance," Academy of Management Journal, 43 (1998), 283--297.

Bushman, Robert, Zhonglan Dai, and Xue Wang, "Risk and CEO Turnover," Journal of Financial Economics, 96 (2010), 381-398.

Chakraborty, Atreya, Shahbaz Sheikh, and Narayanan Subramanian, "Termination Risk and Managerial Risk Taking," Journal of Corporate Finance, 13 (2007), 170-188.

Chevalier, Judith, and Glenn Ellison, "Risk Taking by Mutual Funds as a Response to Incentives," Journal of Political Economy, 105 (1997), 1167-1200.

Chevalier, Judith, and Glenn Ellison, "Career Concerns of Mutual Fund Managers," Quarterly Journal of Economics, 114 (1999), 389-432.

Clarke, Jonathan, and Ajay Subramanian, "Dynamic Forecasting Behavior by Analysts: Theory and evidence," Journal of Financial Economics, 80 (2006), 81-113.

Dasgupta, Amil, and Andrea Prat, "Financial Equilibrium with Career Concerns," Theoretical Economics, 1 (2006), 67-93.

DeFond, Mark L., and Chul W. Park, "The Effect of Competition on CEO Turnover," Journal of Accounting and Economics, 27 (1999), 35-36.

Del Guercio, Diane, and Paula Tkac, "The Determinants of the Flow of Funds of Managed Portfolios: Mutual Funds vs. Pension Funds," Journal of Financial and Quantitative Analysis, 37 (2002), 523-557.

Dong, Zhiyong, Cong Wang, and Fei Xie, "Do Executive Stock Options Induce Excessive Risk Taking?," Journal of Banking and Finance, 34 (2010), 2518-2529.

Eckbo, B. Espen, and Karin S. Thorburn, "Control Benefits and CEO Discipline in Automatic Bankruptcy Auctions," Journal of Financial Economics, 69 (2003), 227-258.

Falato, Antonio, Dan Li, and Todd Milbourn, "To Each According to His Ability? CEO pay and the market for CEOs," Working Paper, 2011.

Fama, Eugene F., "Agency Problems and the Theory of the Firm," Journal of Political Economy, 88 (1980), 288-307.

Foster, Dean P., and Sergiu Hart, " An Operational Measure of Riskiness," Journal of Political Economy, 117 (2009), 785-814.

Fudenberg, Drew, and Jean Tirole, "A `Signal Jamming' Theory of Predation," RAND Journal of Economics, 17 (1986), 366-76.

Gibbons, Robert, and Kevin J. Murphy, "Relative Performance Evaluation for Chief Executive Officers," Industrial and Labor Relations Review, 43 (1990), 30-51.

Gibbons, Robert, and Kevin J. Murphy, "Optimal Incentive Contracts in the Presence of Career Concerns: Theory and Evidence," Journal of Political Economy, 100 (1992), 468-505.

Graham, John R., "Herding among Investment Newsletters: Theory and Evidence," Journal of Finance, 54 (1999), 237-268.

Hermalin, Benjamin, "Managerial Preferences Concerning Risky Projects," Journal of Law, Economics and Organization, 9 (1993), 127-135.

Hermalin, Benjamin E., and Micheal S. Weisbach, "Endogenously Chosen Boards of Directors and Their Monitoring of the CEO," American Economic Review, 88 (1998), 96-118.

Hermalin, Benjamin E., and Micheal S. Weisbach, "Information Disclosure and Corporate Governance," Journal of Finance, forthcoming, 2011.

Hirshleifer, David, and Anjan V. Thakor, "Managerial Conservatism, Project choice, and Debt," Review of Financial Studies, 5 (1992), 437-470.

Hirshleifer, David, and Anjan V. Thakor, "Managerial Performance, Boards of Directors and Takeover Bidding," Journal of Corporate Finance, 1 (1994), 63-90.

Hirshleifer, David, and Anjan V. Thakor, "Corporate Control through Board Dismissals and Takeovers," Journal of Economics and Management Strategy, 7 (1998), 489-520.

Holmstrom, Bengt, "Managerial Incentive Problems: A Dynamic Perspective," in Essays in Economics and Management in Honour of Lars Wahlbeck, (Helsinki: Swedish School of Economics, 1982) (reprinted in the Review of Economic Studies, 66 (1999), 169-182).

Holmstrom, Bengt, and Paul Milgrom, "Aggregation and Linearity in the Provision of Intertemporal Incentives," Econometrica, 55 (1987), 303-28.

Holmstrom, Bengt, and Joan Ricart i Costa, "Managerial Incentives and Capital Management," Quarterly Journal of Economics, 101 (1986), 835-860.

Hong, Harrison, and Jeffrey D. Kubik, "Analyzing the Analysts: Career Concerns and Biased Earning Forecasts," Journal of Finance, 58 (2003), 313-351.

Hong, Harrison, Jeffrey D. Kubik, and Amit Solomon, "Security Analysts' Career Concerns and Herding of Earnings Forecasts," RAND Journal of Economics, 31 (2000), 121-144.

Hu, Ping, Jayant R. Kale, Marco Pagani, and Ajay Subramanian, "Fund Flows, Performance, Managerial Career Concerns, and Risk Taking," Management Science, 57 (2011), 628-646.

Huberman, Gur, and Shmuel Kandel, "On the Incentives for Money Managers: A Signalling Approach," European Economic Review, 37 (1993), 1065-1081.

Huddart, Steven, "Reputation and Performance Fee Effects on Portfolio Choice by Investment Advisers," Journal of Financial Markets, 2 (1999), 227-271.

Jensen, Michael C., and Kevin J. Murphy, "Performance Pay and Top-Management Incentives," Journal of Political Economy, 98 (1990), 225-64.

Ju, Nengjiu, Hayne E. Leland, and Lemma W. Senbet, "Options, Option Repricing and Severance Packages in Managerial Compensation: Their eEfects on Corporate Risk," Working Paper, 2003.

Kaplan, Steven N., and Bernadette Minton, "How has CEO Turnover Changed?," International Review of Finance, forthcoming, 2011.

Kempf, Alexander, Stefan Ruenzia, and Tanja Thiele, "Employment Risk, Compensation Incentives, and Managerial Risk Taking: Evidence from the Mutual Fund Industry," Journal of Financial Economics, 92 (2009), 92-108.

Lambert, Richard A., "Executive effort and the Selection of Risky Projects," RAND Journal of Economics, 17 (1986), 77-88.

Lamont, Owen A., "Macroeconomic forecasts and Microeconomic Forecasters," Journal of Economic Behavior and Organization, 48 (2002), 265-280.

Larraza-Kintana, Martin, Robert M. Wiseman, Luis R. Gomez-Mejia, and Theresa M. Welbourne, "Disentangling Compensation and Employment Risks Using the Behavioral Agency Model," Strategic Management Journal, 28 (2007), 1001-1019.

Malcomson, James M., "Do Managers with Limited Liability Take More Risky Decisions? An Information Acquisition Model," Journal of Economics and Management Strategy, 20 (2011), 83-120.

Malmendier, Ulrike, and Geoffrey Tate, "CEO Overconfidence and Corporate Investment," Journal of Finance, 60 (2005), 2661-2700.

Mehran, Hamid, and Joshua Rosenberg, "The Effect of Employee Stock Options on Bank Investment Choice, Borrowing, and Capital," Federal Reserve Bank of New York Staff Reports 305, 2007.

Mehran, Hamid, George E. Nogler, and Kenneth B. Schwartz, "CEO Incentive Plans and Corporate Liquidation Policy," Journal of Financial Economics, 50 (1998), 319-349.

Milbourn, Todd T., Richard L. Shockley, and Anjan V. Thakor, "Managerial Career Concerns and Investment in Information," RAND Journal of Economics, 32 (2001), 334-351.

Milgrom, Paul, and John Roberts, Economics, Organization and Management, ed. (New Jersey NJ: Prentice-Hall, Englewood Cliffs, 1992).

Murphy, Kevin J., "Executive Compensation," in Handbook of Labor Economics, Orley Ashenfelter and David Card ed. (Amsterdam, North Holland, 1999).

Narayanan, M. P., "Observability and the Payback Criterion," Journal of Business, 58 (1985), 309-323.

Nohel, Tom, and Steven Todd, "Compensation for Managers with Career Concerns: The Role of Stock Options in Optimal Contracts," Journal of Corporate Finance, 11 (2005), 229-251.

Palomino, Frederic, and Andrea Prat, "Risk Taking and Optimal Contracts for Money Managers," RAND Journal of Economics, 34 (2003), 113-37.

Prendergast, Canice , and Lars Stole, "Impetuous Youngsters and Jaded Old-Timers: Acquiring a Reputation for Learning," Journal of Political Economy, 194 (1996), 1105-1134.

PricewaterhouseCoopers, Reward: A New Paradigm?, 2008.

Raviv, Alon, and Yoram Landskroner, "The 2007-2009 Financial Crisis and Executive Compensation: Analysis and a Proposal for a Novel Structure," NYU Finance Working Paper No. FIN-09-003, 2009.

Renée, Adams, and Daniel Ferreira, "A Theory of Friendly Boards," Journal of Finance, 62 (2007), 217-250.

Rothschild, Michael, and Joseph E. Stiglitz, "Increasing Risk: I. A Definition," Journal of Economic Theory, 2 (1970), 225-243.

Sanders, W. M. Gerard, and Donald C. Hambrick, "Swinging for the Fences: The Effects of CEO Stock Options on Company Risk-Taking and Performance," Academy of Management Journal, 50 (2007), 1055-1078.

Scharfstein, David S., and Jeremy C. Stein, "Herd Behavior and Investment," American Economic Review, 80 (1990), 465-479.

Shleifer, Andrei, and Robert W. Vishny, "Management Entrenchment: The case of Manager-Specific Investments," Journal of Financial Economics, 25 (1989), 123-139.

Sirri, Erik R., and Peter Tufano, "Costly Search and Mutual Fund Flows," Journal of Finance, 53 (1998), 1589-1622.

Stein, Jeremy C., "Takeover Threats and Managerial Myopia," Journal of Political Economy, 96 (1988), 61-80.

Wiseman, Robert M., and Luis R. Gomez-Mejia, "A Behavioral Agency Model of Managerial Risk Taking," Academy of Management Review, 23 (1998), 133-153.

Zwiebel, Jeffrey, "Corporate Conservatism and Relative Compensation," Journal of Political Economy, 103 (1995), 1-25.