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.

The thesis of our recent NBER working paper, Seeking Alpha: Excess Risk Taking and Competition for Managerial Talent, is that the root of the problem is the difficulty of rewarding managerial talent when projects can have long-term risk and the market allows executives to move from firm to firm before that risk materializes. For instance, a trader in a financial firm may set up a “carry trade” and then leave the firm before it is known whether it can be determined whether the carry was an actual arbitrage opportunity or simply the reward for risk (so that the trade may eventually “blow up”). In this situation, managers who take risks while moving rapidly between firms raise their performance and pay, while reducing their accountability for failures. When such job churning is possible, competition for managerial talent induces a negative externality, every firm offering an “escape route” to the others’ employees. If instead the market for managerial talent is not very competitive, managers are more likely to be stuck with their initial employer and so be held responsible for project failures. The contrast between these two executive labor market regimes recalls that between the current high-mobility scene and that prevailing around the middle of last century. As Frydman (2007) shows for a balanced panel of U.S. firms from 1936 to 2003, top executives who worked throughout their careers for the same company accounted for 30 percent of the total in 1990-2003, down from 70 percent in 1940-67.

More specifically, we consider a setting in which managers are risk-averse while risk- neutral firms compete for scarce managerial talent. We model managerial talent as “alpha”, the ability to generate high returns without incurring high risks: lacking such talent, managers can generate high returns only by taking correspondingly high risks. But risk only materializes in the long run, so managerial talent can be identified only if the managers who have chosen risky projects stay with their employer for a long enough time. If they leave earlier, the long-term performance of their projects is never learnt, because it is more efficient for the firm to liquidate them.

In this setting, if managers were bound to their employer, then over time firms could determine which managers are talented, and so could also insure managers against the risk of being found to be untalented. There would therefore be two efficiency gains. First, there is better choice of investment projects: when managers’ skills are known they can be assigned to the project they are best suited to manage. Second, there is better risk-sharing: managers who prove to be low-skill can be cross-subsidized at the expense of the more talented.

However, competition for managers can prevent both of these gains. If firms compete aggressively (“seeking alpha”), then managers can leave before the long-term risks that they have incurred materialize. This means that the managers who are discovered to be high-alpha types will extract all rents from their firms by generating competitive offers that reward their talent, and so prevent firms from subsidizing low-alpha managers. Thus where the labor market is competitive, managers face skewed performance rewards before their types are revealed: high-alpha types extract all rents and low-alpha types get no subsidy. Now, if firms assign managers of unknown quality to risky projects (which they will do if the risky projects outperform safe ones by a large enough margin), then managers have the incentive to move to another firm before the risk materializes. There, they will replicate the same behavior. In the aggregate, many managers will churn from one firm to the next, choosing risky projects regardless of their ability to avoid the implied risks. Talented executives will be identified only in the long run: as managers approach the end of their careers, the residual risk of being exposed as low-alpha declines, and so also does the demand for insurance via churning.

For young managers, the benefit of churning is to delay the revelation of their true quality. If projects carry aggregate risk that delays learning individual quality from realized outcomes, then designing such projects is an alternative way for managers to synthesize insurance. Regardless of the way in which managers synthesize insurance—by churning or by undertaking aggregate-risky projects—the end result is inefficiency relative to the case of no competition for managers: since types are not revealed quickly enough, efficient allocation of managers to projects does not take place in time and too many projects fail; along the way, managers’ pay is not commensurate with their actual performance.

The model generates several further results. First, if managers are sufficiently risk-averse, then an increase in the riskiness of projects can increase job churning, hence risk for society as a whole. Second, frictions in the market for managers (e.g. search costs) can actually mitigate inefficiency by reducing managerial churning. Conversely, easy interim liquidation of assets (e.g. securitization markets for loans) can aggravate inefficiency by prompting more churning. Third, limits to deferment of managerial compensation only make it harder for firms to keep employees, heightening the inefficiency that stems from competition for managers.

To summarize, competition in the market for managers generates an inefficiency due to the contractual externality among firms. The financial sector appears to fit our model particularly well since trading and sales skills are highly fungible, prompting firms to compete keenly for “alpha”. And many financial sector products, from AAA-rated mortgage-backed securities to credit default swaps or longevity insurance, contain aggregate risks and have the flavor of earning a carry (interest or insurance premium) in the short run but with potential long-run risks (default or longevity). While there are other explanations for incentives to engage in such risk-taking, e.g., government guarantees for the financial sector without proper risk controls, our model may help explain why it occurred even in parts of the financial sector, such as investment banks and insurance, that were not apparently entitled to government guarantees, explicit or implicit.

The full paper is available for download here.

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