The (Agency) Problem of Risk Incentives within Financial Institutions

In the paper, Downside Risk and Agency Problems in the U.S. Financial Sector: Examining the Effect of Risk Incentives from 2007 to 2010, I consider risk incentives within financial institutions in the presence of two types of potential agency problems: the standard manager-shareholder agency problem and the risk-shifting problem between shareholders and society. First, I evaluate the effect of risk incentives on shareholder returns during the financial crisis. Next, I examine the relation between risk incentives and three downside risk statistics. Value-at-risk resembles a financial institution’s tolerance to losses, expected shortfall resembles losses when the firm does poorly, and marginal expected shortfall resembles an institution’s exposure to loss spillovers from its peers.

From 2007 to 2010, I document a relation between risk incentives and consecutive buy-and-hold returns that is insignificant during the crisis, and positive thereafter. This is in line with shareholder objectives. However, risk incentives also increase downside risk in consecutive years, which is not in line with societal objectives. It follows that the problem is not so much the standard managerial agency problem between managers and shareholders as the risk-shifting problem between shareholders and society.

These results have implications for the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010, and the Corporate and Financial Institution Compensation Fairness Act 2009. The assumption underlying these Acts is that the risk of financial institutions will be more effectively monitored once more power is assigned to shareholders. However, the positive link between risk incentives and downside risk indicates that shareholder-based compensation increased the very losses that the Acts seek to prevent. Considering that the interests of managers are well-aligned with shareholders, a shift towards more shareholder-based compensation may be counterproductive in the financial sector, and exacerbate the conflict of interest between shareholders and society.

Additionally, I find that the losses incurred from risk incentives followed over and above the losses incurred from leverage, and compensation made a distinctly important contribution to the financial crisis. Furthermore, financial institutions adjust leverage in response to changes in asset prices, and leverage can be an instrument for managers to increase risk. Indeed, I find that risk incentives increased downside risk by inducing managers to implement more aggressive leverage policy. However, this effect is small compared to the direct effect of risk incentives on downside risk. This could indicate that to a large extent, much of the variation in the link between incentives and risk is idiosyncratic. Indeed, many elements that play a role in this relation are unobservable, such as managerial ability and effort, risk culture, securitization strategies, and regulatory capital calculations including (but not limited to) expected, ex ante VaR. At the same time, it could also indicate that the total effect of risk incentives pervades other organizational features that are at the discretion of management. Hence, analyzing other management policies could be an interesting alley for future research.

The full paper is available for download here.