Simon Gervais

Work Ethic, Employment Contracts, and Firm Value

We analyze how the work ethic of managers impacts a firms employment contracts, riskiness, growth potential, and organizational structure. Flat contracts are optimal for diligent managers because they reduce risk-sharing costs, but they attract egoistic agents who shirk and unskilled agents who add no value. Stable, bureaucratic firms with low growth potential are more likely to gain value from managerial diligence. Firms that hire from a virtuous pool of agents are more conservative in their investments and have a horizontal corporate structure. Our theory also yields several testable implications that distinguish it from standard agency models. Copyright (c) 2009 the American Finance Association.

Legal Protection in Retail Financial Markets

Given the importance of sound advice in retail financial markets and the fact that financial institutions outsource their advice services, what legal rules maximize social welfare in the market? We address this question by posing a theoretical model of retail markets in which a firm and a broker face a bilateral hidden action problem when they service clients in the market. All participants in the market are rational, and prices are set based on consistent beliefs about equilibrium actions of the firm and the broker. We characterize the optimal law within our modeling context, and derive how the legal system splits the blame between parties to the transaction. We also analyze how complexity in assessing clients and conflicts of interest affect the law. Since these markets are large, the implications of the analysis have great welfare import.

Overconfidence and Team Coordination

We model a team in which the marginal productivity of a player increases with the effort of other players on the team. Because the effort of any player is not observable to any other player, the performance of the team is negatively affected by a free-rider problem and by a lack of effort coordination across players. We show that, in this context, the overconfidence of some players not only enhances team performance but may create a Pareto improvement at the individual level. Indeed, because an overconfident player overestimates his marginal productivity, his decision to exert effort does not require as much expected effort from other players. Knowing that this overconfident player works hard and thus increases their marginal productivity, other players work harder too. This concerted effort by all benefits the team, the rational players and, in some cases, the overconfident player, who overworks but benefits from the positive externality that other players working harder brings about. Such Pareto improvement may provide a rationale for individual overconfidence to perpetuate itself in firms and partnerships.

The Effects of Biased Self-Perception in Teams

Several finance and economics problems involve a team of agents in which the marginal productivity of any one agent increases with the effort of others on the team. Because the effort of each agent is not observable to any other agents, the performance of the team is negatively affected by a free-rider problem and by a lack of effort coordination across agents. In this context, we show that an agent who mistakenly overestimates her own marginal productivity works harder, thereby increasing the marginal productivity of her teammates who then work harder as well. This not only enhances team performance but may also create a Pareto improvement at the individual level. Indeed, although the biased agent overworks, she benefits from the positive externality that other agents working harder generates. The presence of a team leader improves coordination and team value, but self-perception biases can never be Pareto-improving when they affect the leader. Because self-perception biases naturally make agents work harder, monitoring, even when it is costless, may hurt the team by causing an overinvestment in effort. Interestingly, the benefits of self-perception biases may be long-lived even if agents learn from team performance, as the biased agent attributes the teams success to her own ability, and not to the better coordination of the team.

The Industrial Organization of Money Management

We construct and analyze a model of delegated portfolio management in which money managers signal their investment skills via their choice of transparency for their fund. We show that a natural equilibrium is one in which high- and low-skill managers pool in opaque funds, while medium-skill managers separate in transparent funds. In this equilibrium, high-skill managers rely on their eventual performance to separate from low-skill managers over time, saving the monitoring costs associated with transparency. In contrast, medium-skill managers rely on transparency to separate from low-skill managers, especially when it is difficult for investors to tell them apart through performance alone. Low-skill managers prefer mimicking high-skill managers in opaque funds in the hope of replicating their performance and compensation. The model yields several novel empirical predictions that contrast transparent funds (e.g., mutual funds) and opaque funds (e.g., hedge funds).

The Benefits of Volume-Conditional Order-Crossing

We assess the role and viability of an order-crossing or market-clearing mechanism that is automatically triggered only when a minimum number of shares can be crossed. Such a mechanism is naturally more attractive to traders who do not require much immediacy for their trades, as liquidity is cheaper in this market than in a continuous-auction market. The volume condition that we propose is crucial to the effectiveness with which this market complements the continuous-auction market in two important ways. First, when appropriately set, the volume condition endogenously adjusts the probability that market-clearing is triggered and so keeps impatient traders and highly informed traders away. Second, because market-clearing with a large volume condition reduces the effects of adverse selection in this market, patient traders are more willing to place orders in it. As we show, these effects often combine into a Pareto-dominating equilibrium when the continuous-auction market and the crossing mechanism with the right volume condition are both open.