by Dr Hui (Frank) Xu, Research Associate, Cambridge Centre for Finance and Cambridge Endowment for Research in Finance
After the 2008 financial crisis, a Wall Street executive gives a seminar at a university. At the Q&A session, a student in the audience asks him if he knew the investment in subprime mortgage was highly risky.
“Yes, we knew.”
“Then why did you invest it in the first place?”
“Because everyone else was doing it.”
The conversation stops here. Yet, a follow-up question would be why he had to do what everyone else was doing. The question is not trivial at all, as it would help policy makers to align incentives of financial institutions and their executives, keeping economic turmoil like 2008 crisis from occurring again.
A new research paper presented at the recent Cambridge Corporate Finance Theory Symposium by Rui Albuquerque, an Associate Professor at Boston College,
sheds light on this question and the key hinges on relative performance evaluation (RPE) of CEO pay. Here is the takeaway of the ideas illustrated in the paper.
What is RPE?
A CEO manages a firm on behalf of its shareholders. Intuitively, a CEO would be paid more if he runs the firm well. Yet, RPE means that a CEO should be paid more only if he runs the firm well and better than its peers and/or competitors. It is not difficult to understand the logic behind. It is easy to run a firm well in booming macroeconomic conditions, even without too much effort. However, if a firm performs much better than its peers, it certainly shows the CEO’s effort as well as managerial skill and therefore the CEO should get more pay.
In practice, RPE is widely used in the finance industry. According to the paper, US finance industry has the second highest average levels of RPE in CEO pay, just below utilities industry. Other empirical studies suggest 37-60 per cent of the financial institutions have RPE terms in the CEO pay contract.
What is the consequence of RPE?
It seems that RPE is great and incentivizes CEOs to work harder. Nevertheless, the CEOs would respond to the RPE contract terms and one strategy is to invest some common popular projects, such as subprime mortgages during 2005-2007.
A CEO pay contract usually consists of three parts. The first part is base pay, irrelevant of the CEO’s performance; the second part relates to the absolute return brought by the CEO. The CEO can surely try to increase the absolute return by spending more time looking for better projects, but it is still like gambling with nature and luck would play a substantial role; the last part is RPE. By choosing to invest common projects and gaining similar returns, the CEOs are able to hedge the risk from the second part and eventually reduce the total variability of his pay. A CEO prefers lower variability as he is risk averse and dislikes uncertainty.
In sum, it implies that RPE would lead to greater correlation of the overall returns of the financial institutions.
Why do shareholders offer such a contract term?
Shareholders hire a CEO to manage their firms and thus have to pay him. Among others, they prefer paying less to the CEO ceteris paribus. Understanding that a CEO is risk averse and prefers RPE for lower pay variability, they actively offer RPE in the pay contract in exchange for lower base pay, effectively reducing the money directly out of their pocket.
What is the implication of RPE on the society?
It seems to be a win-win situation for both CEOs and shareholders. Is it also good from the perspective of the entire society? Not necessarily. As the shareholders would like to offer and the CEOs are willing to accept RPE, the assets portfolio of the entire financial system is more concentrated on few common and popular projects and industries. Yet, Finance 101 tells us never to put all the eggs in one basket. Under such circumstance, the financial system is very unstable and a tiny shock to a project or industry can propagate through and break down the entire system.
Since the financial crisis, both academics and central bankers are concerned about systemic risk. According to Federal Reserve Bank of New York, systemic risk refers to “financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries”. One fundamental question is where the risk arises. The paper proposes the new channel. Although the paper is not meant to provide “a justification for the US subprime crisis”, one would believe the RPE is certainly a precipitating factor.