Norvald Instefjord

Executive compensation: : A model of disclosure choice

Recent public policy debates have led to increased calls for full transparency of executive compensation. However, in practice, many firms are reluctant to disclose the full details of how they link executive compensation to performance. One possible reason for lack of full disclosure is that managers use their power to hide the details of their compensation plan in order to disguise opportunistic rent extraction. If this is the reason for secrecy, then public policy designed to force firms to provide full disclosure is unlikely to be resisted by shareholders. However, another possible explanation for less than full transparency is that some degree of secrecy about executive compensation may be in the interest of the company and its shareholders. If this explanation is correct, then public policy moves to increase transparency may be met by counter moves designed to protect managers and shareholders from such policies. In this paper we investigate if full disclosure of executive compensation arrangements is always optimal for shareholders. We develop a model where optimal executive remuneration solves a moral hazard problem. However, the degree to which the moral hazard problem affects the shareholders depends on hidden information, so that disclosure of the executive compensation scheme will typically reveal the hidden information, which can be harmful to shareholders. The model derives, therefore, the optimal disclosure policy and the optimal remuneration scheme. We find that the shareholders are better off pre-committing not to disclose the executive compensation scheme whenever possible. Executive directors are shown to be better off too in the absence of disclosure of executive compensation schemes. An argument for mandating disclosure is that it provides better information to shareholders but our analysis demonstrates that disclosure does not necessarily achieve this objective. The results suggest that less than full disclosure can be in the interest of shareholders, the reason for this being that disclosures cannot be made selectively to shareholders but will also be made to strategic opponents. This will be the case if the board of directors and the remuneration committee includes enough independent directors. Whether or not non-disclosure to shareholders is in their interest is however an empirical matter involving a trade-off between the proprietary costs associated with disclosure to shareholders and the costs of potential collusion between executive and non-executive directors associated with non-disclosure.

Corporate Governance and the Cost of Borrowing

This paper analyzes the theoretical link between governance (defined loosely as the degree of protection offered to outside shareholders), and the cost of borrowing. We find, consistent with empirical evidence, that improvements in governance reduce the likelihood of default. Also, we find that improvements in governance will monotonically increase or reduce the cost of debt, where the sign of the relationship depends on the firms restructuring cost in default. Finally, we find that the strength of the governance mechanism can influence the incentives to carry out risk shifting.

The Winner's Curse and Lottery-Allocated IPOs in China

This is the first study of Rocks (1986) winners curse hypothesis in which over-subscribed IPOs are allocated by a pure lottery mechanism. It employs a unique dataset of 562 Chinese IPOs 1996-2001 which provides information for the estimation of allocation-weighted returns. The results provide much stronger support than hitherto for the winners curse hypothesis. Allocations are inversely related to underpricing in line with adverse selection. Weighting by allocation dramatically reduces median abnormal returns more than 200-fold from 116% and uninformed investors earn a median return of just 0.51%. The winners curse can explain underpricing in our sample of Chinese IPOs.

Corporate Governance and the Cost of Borrowing: CORPORATE GOVERNANCE AND THE COST OF BORROWING

This paper analyzes the theoretical link between governance (defined loosely as the degree of protection offered to outside shareholders), and the cost of borrowing. We find, consistent with empirical evidence, that improvements in governance reduce the likelihood of default. Also, we find that improvements in governance will monotonically increase or reduce the cost of debt, where the sign of the relationship depends on the firms restructuring cost in default. Finally, we find that the strength of the governance mechanism can influence the incentives to carry out risk shifting.

A simple model of market liquidity

Abstract The literature on illiquid markets is relatively large although little theoretical work has been done in terms of endogenizing the liquidity problem. This paper presents a simple model in which liquidity costs are entirely endogenous, i.e. the traders can technically trade at zero costs but in equilibrium these are incurred. The liquidity problem causes (i) the return on the asset to be greater, (ii) the volume of trade to be less, and (iii) the return on the asset to be more risky, than it otherwise would have been. All are characteristics associated with illiquid markets.

Financial Regulation: Regulatory Arbitrage and Regulatory Harmonization

This paper analyzes the problem of designing optimal financial regulation when regulatory arbitrage allows competition from other regulators, and whether regulatory harmonization as a means to curb regulatory arbitrage is desirable. We find (i) that regulatory arbitrage and competition matter in the sense that the optimal autarky approach to regulation may not be optimal in open economies; (ii) regulatory arbitrage that takes place in equilibrium is not as important as the possibility of regulatory arbitrage and the associated impact on regulatory competition; and (iii) regulatory diversity can be welfare optimal even though it leads to more regulatory arbitrage activity than regulatory harmonization.

FINANCIAL INNOVATION AND DELEGATION OF CONTROL

The literature on security design has traditionally assumed that control of investment and production rests with the entrepreneur even after flotation. In this article, the author relaxes this assumption, which is both unnecessarily strict and unrealistic. The contribution is twofold. First, he shows that when control is delegated during flotation, financial innovation is a trade-off between agency costs (arising from principal agent relationships) and targeting costs (arising from the inability to split the cash flow). Second, the author shows that unlevered equity or the use of debt, which can be issued without defaulting in equilibrium, is an optimal means of financing.

Rules vs Principles Based Financial Regulation

We study the relative strengths and weaknesses of principles based and rules based systems of regulation. In the principles based systems there is clarity about the regulatory objectives but the process of reverse-engineer these objectives into meaningful compliance at the firm level is ambiguous, whereas in the rules based systems there is clarity about the compliance process but the process of forward-engineer this into regulatory objectives is also ambiguous. The ambiguity leads to social costs, the level of which is influenced by regulatory competition. Regulatory competition leads to a race to the bottom effect which is more harmful under the principles based systems. Regulators applying principles based systems make dramatic changes in the way they regulate faced with regulatory competition, whereas regulators applying rules based systems make less dramatic changes, making principles based regulation less robust than rules based regulation. Firms prefer a rules based system where the cost of ambiguity is borne by society rather than the firms, however, when faced with regulatory competition they are better off in principles based systems if the direct costs to firms is sufficiently small. We discuss these effects in the light of recent observations.

Foreign Direct Investment Subsidy

We address the problem of optimal form and timing of FDI subsidy, and the impact of competition on these. We find that the optimal subsidy must include an element of discouragement against delaying the timing of the investment for the firm to prevent the firm from extracting rent from the host country. The optimal timing depends on factors related to the industry where the investment is made, and factors related to the welfare effects of the investment as well as the market for subsidy. These results generate empirical predictions as the subsidy we are the most likely to see is the subsidy that speeds up the investment the most. The factors influencing subsidy are the welfare effects relative to the amortised investment cost and the strategic commitment value of investment and subsidy.

Debt Overhang and Debt Restructuring

This paper analyzes how debt forgiveness and exchange offers resolve inefficiencies associated with debt overhang in a dynamic setting. In a static model debt forgiveness and exchange offers are equivalent -- in a dynamic model they are not. Debt forgiveness is feasible as a means to restructure debt when the firm expands into a competitive market, whereas exchange offers are necessary to eliminate the inefficiency of expansion into uncompetitive markets. We discuss the model in the light of existing empirical evidence and the empirical implications of the model.