Tag: Risk-taking


Do Women Stay Out of Trouble?

Anup Agrawal is Professor of Finance at the University of Alabama. This post is based on an article authored by Professor Agrawal; Binay Adhikari, Visiting Assistant Professor of Finance at Miami University; and James Malm, Assistant Professor of Finance at the College of Charleston.

Does the presence of women in a firm’s top management team affect the risk of the firm being sued? A large literature in economics and psychology finds that women tend be more risk-averse, less overconfident, and more law-abiding than men. As more women reach top management positions, these gender differences have implications for firms’ policies and performance. As Neelie Kroes, then European Competition Commissioner provocatively asked in a speech at the World Economic Forum, “If Lehman Brothers had been Lehman Sisters, would the financial crisis have happened like it did?” (see New York Times, February 1, 2009).

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Restraining Overconfident CEOs Through Improved Governance

Mark Humphery-Jenner is Senior Lecturer at the UNSW Business School. This post is based on the article Restraining overconfident CEOs through improved governance: Evidence from the Sarbanes-Oxley Act, authored by Mr. Humphery-Jenner, Suman Banerjee, Associate Professor in the Department of Economics and Finance at the University of Wyoming, and Vikram Nanda, Professor of Finance at Rutgers University.

In our recent paper, Restraining overconfident CEOs through improved governance: Evidence from the Sarbanes-Oxley Act, forthcoming in the Review of Financial Studies, we use the joint passage of the Sarbanes-Oxley Act and changes to the NYSE/NASDAQ listing rules to analyze the impact of improved governance in moderating the behavior of overconfident CEOs. Overconfidence can lead managers to overestimate returns and underestimate risk. The literature suggests that while some CEO overconfidence can benefit shareholders, a highly distorted view of risk-return profiles can destroy shareholder value. An intriguing question is whether there are ways to channel the drive and optimism of highly overconfident CEOs while curbing the extremes of risk-taking and over-investment associated with such overconfidence. We explore such a possibility in this paper. Specifically, we investigate whether appropriate restraints on CEO discretion and the introduction of diverse viewpoints on the board serve to moderate the actions of overconfident CEOs and, in the end, benefit shareholders.

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CEO Stock Ownership Policies—Rhetoric and Reality

The following post comes to us from Nitzan Shilon at Peking University School of Transnational Law. This post is based on his recent study, CEO Stock Ownership Policies—Rhetoric and Reality. He conducted this study while being a Fellow in Law and Economics and an S.J.D. (Doctor of Laws) candidate at Harvard Law School.

I recently published a study titled CEO Stock Ownership Policies—Rhetoric and Reality. This study is the first academic endeavor to analyze the efficacy and transparency of stock ownership policies (SOPs) in U.S. public firms. SOPs generally require managers to hold some of their firms’ stock for the long term. Although firms universally adopted these policies and promoted them as a key element in their mitigation of risk, no one has shown that such policies actually achieve the important goals that they have been established to achieve. My study shows that while SOPs are important in theory, they are paper tigers in practice. It also shows that firms camouflage the weakness of these policies in their public filings. Therefore I put forward a proposal to make SOPs transparent as a first step in improving their content. My findings have important implications for the ongoing policy debates on corporate governance and executive compensation.

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Corporate Risk-Taking and the Decline of Personal Blame

Steven L. Schwarcz is the Stanley A. Star Professor of Law & Business at Duke University School of Law.

Federal agencies and prosecutors are being criticized for seeking so few indictments against individuals in the wake of the 2008 financial crisis and its resulting banking failures. This article analyzes why—contrary to a longstanding historical trend—personal liability may be on the decline, and whether agencies and prosecutors should be doing more. The analysis confronts fundamental policy questions concerning changing corporate and social norms. The public and the media perceive the crisis’s harm as a “wrong” caused by excessive risk-taking. But that view can be too simplistic, ignoring the reality that firms must take greater risks to try to innovate and create value in the increasingly competitive and complex global economy. This article examines how law should control that risk-taking and internalize its costs without impeding broader economic progress, focusing on two key elements of that inquiry: the extent to which corporate risk-taking should be regarded as excessive, and the extent to which personal liability should be used to control that excessive risk-taking.

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Governance, Risk Management, and Risk-Taking in Banks

René Stulz is Professor of Finance at Ohio State University.

One might be tempted to conclude that good risk management in banks reduces the exposure to danger. However, such a view of risk management ignores that banks cannot succeed without taking risks that are ex ante profitable. Consequently, taking actions that reduce risk can be costly for shareholders when lower risk means avoiding valuable investments and activities that have higher risk. Therefore, from the perspective of shareholders, better risk management cannot mean risk management that is more effective at reducing risk in general since reducing risk in general would mean not taking valuable projects. If good risk management does not mean low risk, then what does it mean? How is it implemented? What are its limitations? What can be done to make it more effective? In my article, Governance, Risk Management, and Risk-Taking in Banks, which was recently made publicly available on SSRN, I provide a framework to understand the role, the organization, and the limitations of risk management in banks when it is designed from the perspective of increasing the value of the bank for its shareholders and review the existing literature.

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Banks, Government Bonds, and Default

The following post comes to us from Nicola Gennaioli, Professor of Finance at Bocconi University; Alberto Martin, Research Fellow at the International Monetary Fund; and Stefano Rossi of the Finance Area at Purdue University.

Recent events in Europe have illustrated how government defaults can jeopardize domestic bank stability. Growing concerns of public insolvency since 2010 caused great stress in the European banking sector, which was loaded with Euro-area debt (Andritzky (2012)). Problems were particularly severe for banks in troubled countries, which entered the crisis holding a sizable share of their assets in their governments’ bonds: roughly 5% in Portugal and Spain, 7% in Italy and 16% in Greece (2010 EU Stress Test). As sovereign spreads rose, moreover, these banks greatly increased their exposure to the bonds of their financially distressed governments (2011 EU Stress Test), leading to even greater fragility. As The Economist put it, “Europe’s troubled banks and broke governments are in a dangerous embrace.” These events are not unique to Europe: a similar relationship between sovereign defaults and the banking system has been at play also in earlier sovereign crises (IMF (2002)).

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Excess Risk Taking and Competition for Managerial Talent

The following post comes to us from Viral Acharya, Professor of Finance at NYU; Marco Pagano, Professor of Economic Policy at the University of Naples Federico II; and Paolo Volpin, Professor of Finance, Cass Business School.

Excessive risk-taking by financial institutions and overly generous executive pay are widely regarded as key factors in the 2007-09 crisis. In particular, it has become commonplace to blame banks and securities companies for compensation packages that reward managers (and more generally, other risk-takers such as traders and salesmen) generously for making investments with high returns in the short run but large risks that emerge only in the long run. As governments have been forced to rescue failing financial institutions, politicians and the media have stressed the need to cut executive pay packages and rein in incentives based on options and bonuses, making them more dependent on long-term performance and in extreme cases eliminating them outright. It is natural to ask whether this is the right policy response to the problem. It is crucial to ask what is the root of the problem—that is, precisely which market failure produced excessive risk-taking.

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Risk Choice under High-Water Marks

The following post comes to us from Itamar Drechsler of the Department of Finance at New York University Stern School of Business.

High-water mark (HWM) contracts are the predominant compensation structure for managers in the hedge fund industry. In the paper, Risk Choice under High-Water Marks, forthcoming in the Review of Financial Studies, I seek to understand the optimal dynamic risk-taking strategy of a hedge fund manager who is compensated under such a contract. This is both an interesting portfolio-choice question, and one with potentially important ramifications for the willingness of hedge funds to bear risk in their role as arbitrageurs and liquidity providers, especially in times of crises. High-water mark mechanisms are also implicit in other types of compensation structures, so insights from this question extend beyond hedge funds. An example is a corporate manager who is paid performance bonuses based on record earnings or stock price and whose choice of projects influences the firm’s level of risk.

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Understanding the Failures of Market Discipline

The following post comes to us from David Min of University of California, Irvine School of Law.

Last week, James Kwak (UConn law professor, co-author of 13 Bankers and White House Burning, and blogger at the Baseline Scenario) provided a nice writeup of some of the key issues I identify in my paper, Understanding the Failures of Market Discipline, recently posted to SSRN. But I wanted to take a few words to provide a slightly more detailed explanation of my work.

“Market discipline”—the notion that short-term creditors (such as bank depositors) can efficiently identify and rein in bank risk—has been a central pillar of banking regulation since the 1980s. Obviously, market discipline did not prevent the buildup of bank risk that caused the recent financial crisis, but the general consensus has been that this failure was due to structural impediments to the effective operation of market discipline—such as misaligned incentives, a lack of transparency, or moral hazard caused by implicit guarantees—rather than any problems with the concept itself. As a result, a major point of emphasis in financial regulatory reform efforts has been to improve and strengthen market discipline.

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Financing as a Supply Chain

The following post comes to us from Will Gornall and Ilya Strebulaev, both of the Finance Area at Stanford University.

In our recent NBER working paper, Financing as a Supply Chain: The Capital Structure of Banks and Borrowers, we propose a novel framework to model joint debt decisions of banks and borrowers. Our framework combines the models used by bank regulators with the models used to explain capital structure in corporate finance. This structure can be used to explore the quantitative impact of government interventions such as deposit insurance, bailouts, and capital regulation.

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