Agency Costs in the Era of Economic Crisis

The following post comes to us from Mira Ganor of The University of Texas School of Law.

In the paper, Agency Costs in the Era of Economic Crisis – The Enhanced Connection between CEO Compensation and Corporate Cash Holdings, which was recently made publicly available on SSRN, I examine the evolution of the practice of cash hoarding following the Great Recession. The results suggest that managerial behavior, as evidenced by the elasticity of cash holdings as a function of total director compensation, has changed significantly in 2008 with economically meaningful implications. The effect was somewhat diminished the following year, which may be attributed to the growth and stimulus of the second half of 2009, but peaked again in 2010. In particular, I find that following the Great Recession managerial compensation has become positively correlated with the level of corporate cash holdings, suggesting that agency costs contribute to cash retention in times of financial distress.

It is possible that high managerial compensation influences the managers to be more risk averse and thus affects the managers’ decision to retain cash. Since diversified shareholders are likely to be less risk averse than the managers at times of financial crisis, when it is harder to find a comparable alternative job and the probability of complete failure increases, it may well be that the cash hoarding practice is at a suboptimal level and comes at the expense of shareholder value. Thus, the influence of the size of the managerial compensation on the manager’s risk tolerance should be taken into account when evaluating managerial pay.

To be sure, the managers who hold cash may be waiting for an opportunity to invest the cash and not just to reserve the cash in case the need arises. It may also be the case that US tax on foreign income explains parts of the reasons for cash hoarding. Yet these explanations do not seem to address the correlation between the cash holdings and the manager’s annual compensation. Nor do these explanations provide an answer to why there is a change in the elasticity of the cash holdings as a function of the manager’s annual compensation following the financial crisis.

Since the Great Recession has introduced a major shock to the market system, it is not surprising that the market has reacted in ways that cannot be predicted by simply studying the market behavior in previous post crisis years. To be sure, the positive and economically meaningful correlation between the managerial compensation and corporate cash holdings is but one such reaction. Further study of the new connections in the recalibrated economic system will enhance our understanding of corporate governance and help implement and tailor new measures, such as the Dodd-Frank’s say-on-pay provisions, to better fit the current market needs.

The full paper is available for download here.

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