Christian Laux

Board Committees, CEO Compensation, and Earnings Management

We analyze the effect of committee formation on how corporate boards perform two main functions: setting CEO pay and overseeing the financial reporting process. The use of performance-based pay schemes induces the CEO to manipulate earnings, which leads to an increased need for board oversight. If the whole board is responsible for both functions, it is inclined to provide the CEO with a compensation scheme that is relatively insensitive to performance in order to reduce the burden of subsequent monitoring. When the functions are separated through the formation of committees, the compensation committee is willing to choose a higher pay-performance sensitivity as the increased cost of oversight is borne by the audit committee. Our model generates predictions relating the board committee structure to the pay-performance sensitivity of CEO compensation, the quality of board oversight, and the level of earnings management. JEL classifications: D23, D73, G34, K22, L29

Limited Liability and Incentive Contracting with Multiple Projects

I examine a principal-agent model with multiple projects where a risk-neutral manager is protected by limited liability. The analysis has several interesting implications: (i) incentive problems are shown to be a natural source of economies of scope, as combining multiple projects under the management of a single manager relaxes the limited-liability constraint; (ii) as a result, managers may be overloaded with work and exert inefficiently high effort; and (iii) the analysis has implications for the optimal allocation of projects to different managers. Copyright 2001 by the RAND Corporation.

Catastrophe Bonds and Reinsurance: The Competitive Effect of Information-Insensitive Triggers

We identify a new benefit of index or parametric triggers. Asymmetric information between reinsurers on an insurers risk affects competition in the reinsurance market: reinsurers are subject to adverse selection, since only high-risk insurers may find it optimal to change reinsurers. The result is high reinsurance premiums and cross-subsidization of high-risk insurers by low-risk insurers. A contract with a parametric or index trigger (such as a catastrophe bond) is insensitive to information asymmetry and therefore alters the equilibrium in the reinsurance market. Provided that basis risk is not too high, the introduction of contracts with parametric or index triggers provides low-risk insurers with an alternative to reinsurance contracts, and therefore leads to less cross-subsidization in the reinsurance market.

Procyclicality of US Bank Leverage

In light of the current debate about the link between accounting and financial stability, we investigate the determinants of procyclical book leverage for US commercial and savings banks. We find that total asset growth and GDP growth are both positively related to book leverage growth. Our evidence is not consistent with the notion that fair value accounting contributes to procyclical leverage or that historical cost accounting reduces procyclicality. Overall, the business model of banks and the level of the regulatory capital ratio and book leverage seem to be more important for procyclical leverage than accounting or regulatory risk weights.

Procyclicality of U.S. Bank Leverage: PROCYCLICALITY OF U.S. BANK LEVERAGE

In light of the current debate about the link between accounting and financial stability, we investigate the determinants of procyclical book leverage for U.S. commercial and savings banks. We find that total asset growth and GDP growth are both positively related to book leverage growth. Our evidence is not consistent with the notion that fair value accounting contributes to procyclical leverage or that historical cost accounting reduces procyclicality. Overall, the business model of banks is more important for procyclical leverage than accounting or regulatory risk weights.

The Adverse Effect of Information on Governance and Leverage

We study the effect that internal information systems have upon a firms leverage and corporate governance choices. Information systems lower governance costs by facilitating more targeted interventions. But they also generate asymmetric information between firms and their investors. As a result, firms may attempt to signal their superior quality by assuming more leverage. In some circumstances, this can reduce governance incentives and result in inferior outcomes. Investors anticipate this effect, and it renders information systems inefficient.

Regulating Bank CEO Compensation and Active Boards

We analyze the role of using CEO compensation and capital requirements in bank regulation. With a passive uninformed board that delegates the choice of bank strategy to the CEO, requiring a compensation contract where the CEO receives a fixed fraction of total bank payoff eliminates the risk shifting problem and can implement first best; no additional regulatory limit on bank leverage is needed. With an informed, active board that represents shareholder interests, however, there exists no CEO compensation that assures that the socially optimal level of risk is chosen. The optimal policy mix consists of deferred compensation for the CEO, a bonus cap or a compensation that is linear in total payoff, and a constraint on bank leverage. Regulating CEO compensation allows to relax regulatory capital requirements.

Performance Measurement and Information Production

When performance measures are used for evaluation purposes, agents have some incentives to learn how their actions affect these measures. We show that the use of imperfect performance measures can cause an agent to devote too many resources (too much effort) to acquiring information. Doing so can be costly to the principal, because the agent can use information to game the performance measure to the detriment of the principal. We analyze the effect of endogenous information acquisition on the optimal incentive strength and the quality of the performance measure used.

Understanding Bank Payouts During the Crisis of 2007-2009

We provide an extensive analysis of the payout policy of U.S. banks in 2007-2008 to identify the main drivers of their payout decisions. We use established models that relate dividends to fundamentals to provide a benchmark for the normal level of payouts. Based on these models, bank dividends appear excessive in 2007, but not in 2008. We exploit cross-sectional heterogeneity to examine why bank payouts change during the crisis. Banks with low capital ratios have low abnormal payouts during the crisis, and banks with high managerial ownership also have lower payouts. Managers of banks that reduce dividends in 2008 buy more shares than before the crisis. Finally, we examine the correlation between dividends and future performance, as well as announcement returns around dividend changes and repurchases. We find that banks that reduce dividends in 2008 perform worse in 2009, but we do not find that announcements of dividend cuts are associated with a significant negative price reaction in 2007-2008. Our results in general do not support the active wealth transfer hypothesis and provide mixed evidence on banks fearing the adverse effect of dividend cuts.We provide an extensive analysis of the payout policy of U.S. banks around the financial crisis. We find no evidence that banks systematically used their payout policy to transfer wealth to shareholders in anticipation of future problems. Banks hardly reduced dividends until 2009, but significantly reduced share repurchases in 2008. Using established models that relate dividends to fundamentals, dividends in 2008 do not appear excessive. Banks that reduce dividends in 2008 do worse in 2009 than other banks. Insiders of banks that do not reduce dividends in 2008 do not sell more shares than before the crisis.

Insuring Non-Verifiable Losses

Insurance contracts are often complex and difficult to verify outside the insurance relation. We show that standard one-period insurance policies with an upper limit and a deductible are the optimal incentive-compatible contracts in a competitive market with repeated interaction. Optimal group insurance policies involve a joint upper limit but individual deductibles and insurance brokers can play a role implementing such contracts for the group of clients. Our model provides new insights and predictions about the determinants of insurance.