Pascal Frantz

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.

Discretionary write-downs, write-offs, and other restructuring provisions: a signaling approach

This paper introduces a model seeking to explain the discretionary write-downs, write-offs, and other restructuring provisions reported by managers. The model comprises a firm, a manager, and a financial market. The firm is about to be restructured. The manager has some private information about the likelihood of success of his restructuring action. The manager may recognise all or part of the expenditure associated with his future restructuring action by reporting a discretionary restructuring provision. The manager chooses whether or not to report a provision, recognising the impact of the provision on his compensation. The paper shows how, under certain conditions, the manager may credibly communicate his private information to investors through his provision policy. Testable implications are consistent with the empirical evidence reported by Strong and Meyer (1987), Elliott and Shaw (1988), and Zucca and Campbell (1992).

Discretionary Accounting Choices: A Debt-Covenants Based Signalling Approach

Abstract This paper seeks to explain the discretionary accounting choices made by managers in a world characterised by asymmetric information between managers and investors. It considers a firm whose capital structure consists of both debt and equity, a manager who protects the interests of the firms existing shareholders, and a financial market. The manager is committed to engage in an investment opportunity and needs to raise some equity to finance it. He is furthermore endowed with some private information about his firms future earnings. The paper shows how, under certain conditions, the manager may credibly communicate his private information to investors through his accounting choices. In this equilibrium, the selection of balance sheet strengthening and income increasing accounting choices signals unfavourable information while the use of balance-sheet weakening and income- decreasing accounting choices signals favourable private information. The latter firms should thus experience positive abnor...

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.

Review of ‘Dirty surplus accounting flows: international evidence’

The paper presented at the Cass Conference by John O’Hanlon, ‘The effect of omitting dirty surplus flows from residual income value estimates: international evidence’, seeks to contribute to the debate on the desirability of dirty-surplus accounting. Standard setters and accounting academics have been increasingly concerned about a relative lack of transparency of dirty surplus accounting flows and its potential for earnings management (Brief. and Peasnell, 1996). There is, however, surprisingly little empirical research on both the relative magnitude of dirty surplus accounting flows and its impact. The paper reviewed documents the magnitude of aggregate dirty surplus flows relative to aggregate net income for French, German, UK and US companies. It examines the effect of the omission of various dirty surplus flows in creating bias and inaccuracy in perfect-foresight residual income valuation estimates with respect to clean-surplus estimates and observed market values. The magnitude of aggregate dirty surplus flows relative to aggregate net income is shown to vary substantially across countries and regimes. Exclusive of merger accounting items, it is highest for continental European companies. Inclusive of merger accounting items, it is highest for US companies. Bias caused by the omission of various dirty surplus flows in perfect-foresight residual income valuation estimates with respect to clean surplus estimates is shown to be limited to goodwill-related flows. Inaccuracy caused by the omission of various dirty surplus flows is shown to be substantial for all types of dirty surplus flows. However, there is no evidence that clean surplusbased formulations are superior to dirty surplusbased formulations as far as bias and inaccuracy with respect to observed market values are concerned. The paper presented at the Cass Conference clearly contributes to our understanding on dirty surplus accounting flows. Conference participants however felt that the paper would benefit from a change in focus away from valuation with perfect foresight:

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.

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.

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.

What are the Determinants of Mergers and Acquisitions in Banking

This study investigates the determinants of the likelihood of being involved in mergers and acquisitions (M&As) in banking. Given that the M&A market has been especially active in banking, the main aim here is to test whether it is possible to predict ex ante potential acquirers and targets on the basis of a set of bank specific and regulatory/institutional characteristics. We suggest that significant implications follow. Professional investors in the secondary markets would have at their disposal a method of identifying firms more likely to be targets and acquirers, and hence to select the stocks to be included in their portfolios. Managers in the banking industry would have a way to identify the probability of running into an M&A operation, and therefore to put in place mechanisms to favour or to block it.