The recent financial crisis saw CEOs undertake risky actions that cost billions of pounds. Examples included irresponsible subprime lending and over-expansion through excessive leverage. Moreover, this problem extends beyond financial institutions to other corporations. For example, in the UK, Punch Taverns accumulated £2.3bn of debt through an expansion spree before the financial crisis, which has long been threatening its viability.
CEOs have incentives to take excessive risk because they are compensated primarily with equity-like instruments, such as stock and options. The value of equity rises if a risky project pays off, but it is protected by limited liability if things go wrong – thus, equity gives them a one-way bet. Of course, executives are incentivised not only by their equity, but the threat of being fired and reputational concerns. However, the risk of being fired mainly depends on the incidence of bankruptcy and not the severity of bankruptcy. For simplicity, assume that the CEO is fired upon any level of bankruptcy. Then, regardless of whether debtholders recover 90c per $1 (a mild bankruptcy) or 10c per $1 (a severe bankruptcy), the CEO will be fired and his equity will be worthless. Thus, if a firm is teetering towards liquidation, rather than optimally accepting a mild bankruptcy, the CEO may “gamble for resurrection”. If the gamble fails, the bankruptcy will be severe, costing debtholders (and society) billions of pounds – but the CEO is no worse off than in a mild bankruptcy, so he might as well gamble.
This problem of “risk-shifting” has long been known, but is difficult to solve. One remedy is for bondholders to impose covenants that cap a firm’s investment. But covenants can only restrict the level of investment – they cannot distinguish between good and bad investment. Thus, covenants may unduly prevent good investment. A second remedy is to cap executives’ equity ownership – but this has the side-effect of reducing their incentives to engage in productive effort.
My paper in the May 2011 issue of the Review of Finance, entitled “Inside Debt”, shows that the optimal solution to risk-shifting involves incentivising managers through debt as well as equity. By aligning the manager with debtholders as well as equityholders, this causes them to internalise the costs to debtholders of undertaking risky actions. But why should compensation committees - who are elected by shareholders - care about debtholders? Because if potential lenders expect the CEO to risk-shift, they will demand a high interest rate and covenants, ultimately costing shareholders.
Surprisingly, I find that the optimal pay package does not involve giving the CEO the same debt-equity ratio as the firm. If the firm is financed with 60% equity and 40% debt, it may be best to give the CEO 80% equity and 20% debt. The optimal debt ratio for the CEO is usually lower than the firm’s, because equity is typically more effective at inducing effort. However, the optimal debt ratio is still nonzero - the CEO should be given some debt.
Academics love proposing their pet solutions to real-world problems, but many solutions are truly “academic” and it is hard to see whether they will actually work in the real world. For example, the widely-advocated “clawbacks” have never been tried before, and their implementability is in doubt. But here, we have significant evidence to guide us. Many CEOs already receive debt-like securities in the form of defined benefit pensions and deferred compensation. In the U.S., these instruments have equal priority with unsecured creditors in bankruptcy and so are effectively debt. Moreover, since 2006, detailed data on debt-like compensation has been disclosed in the U.S., allowing us to study its effects. Studies have shown that debt-like compensation is associated with looser covenants and lower bond yields, suggesting that debtholders are indeed reassured by the CEO’s lower incentives to risk-shift. It is also associated with lower bankruptcy risk, lower stock return volatility, lower financial leverage, and higher asset liquidity.
Indeed, the idea of debt-based pay has started to catch on. The President of the Federal Reserve Bank of New York, William Dudley, has recently been proposing it to change the risk culture of banks. In Europe, the November 2011 Liikanen Commission recommended bonuses to be partly based on “bail-inable” debt. Indeed, UBS and Credit Suisse have started to pay bonuses in the form of contingent convertible (CoCo) bonds. These are positive moves to deter risk-shifting and prevent future crises. Of course, as with any solution, debt-based compensation will not be appropriate for every firm, and the optimal level will differ across firms. But, the standard instruments of stock, options, and long-term incentive programmes have proven not to be fully effective, and so it is worth giving serious consideration to another tool in the box.