Aurora Borealis
1 November 2013 CFA Institute Journal Review

The Prevention of Excess Managerial Risk Taking (Digest Summary)

  1. Florian B. Schweizer

Executive compensation packages commonly use severance payments as a way to help prevent excessive risk taking. The authors take a scientific approach to assessing the utility of severance packages in shaping managerial behavior.

What’s Inside?

Using a model to try to capture the behavior of managers under different compensation arrangements, the authors investigate the impact of severance payments on risk taking. Managers could be inclined to take excessive risks to compensate for a period of poor performance. The authors show that those severance payments could also prevent managers from taking negative net present value risks.

How Is This Research Useful to Practitioners?

Compensation arrangements are subject to intensive debate, particularly since the financial crisis. The authors offer a scientific approach to what is often an emotionally charged discussion. They use a game theory approach to describe a situation in which a firm searches for a new CEO. The key question is how to prevent managers from taking excessive risk. The authors suggest that in the case of mediocre managers, severance payments are the least expensive way to discourage excessive risk taking. Manager quality is an important parameter that is incorporated into the model. In the optimal case, severance payments are made to CEOs who are delivering mediocre profits. In the case of complete failure, no severance payments are made. Another important parameter is firm size. The authors suggest that a larger company size is optimal only for high-quality managers.

For risk taking to make sense from a manager’s perspective, the probability of a high-profit outcome must increase as the probability of failure increases. This result implies that ex ante there is a trade-off between risk and return and, therefore, taking risk reduces firm value from the manager’s point of view. This point is the crucial point for the authors: Severance payments should not be there to protect a CEO and thus incentivize risk taking. Rather, the authors introduce the assumption that expected profit should increase when the CEO chooses a higher probability of success. Because CEOs are risk-neutral agents in the model, the CEO’s payoff is simply expected earnings. After introducing some more assumptions, the authors try to determine some optimal contract designs that lead to corresponding outcomes. They argue that severance payments can be part of an optimal contract, but they must depend on performance. In their model, failure can only result from undesirable risk taking; thus, an optimal contract has to discourage that behavior.

How Did the Authors Conduct This Research?

The authors use a two-period model in which possible outcomes are either a high profit or a low profit. The higher the targeted profit, the lower the expected profit because there has to be a trade-off between risk and return. Furthermore, the agent/CEO can be fired after one period as specified in the contract.

The authors consider different cases for optimal contract design. In particular, they distinguish between boards that can assess the quality of potential hires and boards that cannot. They argue that high-quality CEOs should expand firm size beyond first-optimal size. Another topic the authors suggest for study with a multiperiod model is the timing of severance payments. It has been shown that such payments should be deferred as long as possible. The rationale is that it minimizes the probability of a low-quality CEO imitating a high-quality one, which lowers expected wage costs.

Abstractor’s Viewpoint

The model presented allows the study of some topics that are subject to intense public debate, such as the mere existence of severance payments. Another important message is that severance payments should be paid only at retirement. A lot of relevant factors that managers have limited or no influence on must be excluded, so the conclusions of the model are only partly transferrable to the real world. But this limitation does not limit the usefulness of the systematic thinking.

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