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Regulation & Oversight


Legal, Political and Institutional Constraints on the Financial Crisis Policy Response
by Phillip Swagel

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The story of the financial crisis response can be told through the lens of evolving legal and political constraints. In late 2007 and early 2008, while policymakers recognized weaknesses in the system, they believed that conventional monetary and fiscal responses such as Fed lending and a modest fiscal stimulus would suffice to buoy the US economy while the imbalances that had built up during the housing bubble were resolved. By the time of the Bear Stearns bailout in March 2008, the usual methods were clearly perceived to be inadequate, and the Fed was making discretionary choices to invoke authority reserved for “unusual and exigent” circumstances to respond to the potential collapse of a nonbank financial firm. In September 2008, the Fed’s ability to use this discretionary authority had reached its limits, and the imminent risk of financial crisis led to the Troubled Asset Relief Program.  The advent of the TARP capital injections facilitated a program of guarantees by the Federal Deposit Insurance Corporation to support bank funding, undertaken with existing legal authority but in an extraordinary way. Together, these actions reassured market participants that the US financial sector would not collapse and marked the beginning of the stabilization from the crisis.

Professor Swagel notes that there will inevitably be another financial crisis, and the response will be shaped by both the lessons learned from recent history and the statutory and political changes in the wake of the crisis.  The paper thus concludes by discussing changes in constraints since the crisis, with a focus on two developments: 1) the political reality that there will not in the near future be another wide-ranging grant of fiscal authority as was given with the Troubled Asset Relief Program, and 2) the new legal authorities provided in the Wall Street Reform and Consumer Protection Act of 2010, commonly known as the Dodd–Frank law.


Discussion of Cost-Benefit Analysis in SEC Rulemaking
by Albert S. (Pete) Kyle
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On April 16, 2012 at Columbia University’s Law and Economics of Capital Markets Fellows Workshop, Professor Kyle discussed the cost-benefit analysis of SEC rulemaking. As a framework for his presentation, Professor Kyle examined the six recommendations of the SEC’s Office of Inspector General study on the topic and offered his opinion of each recommendation.

Financial Economists Roundtable (FER) Statement of the Financial Economists Roundtable on Reforming the OTC Derivatives Markets
by Chester S. Spatt, Darrell Duffie and Albert S. (Pete) Kyle
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Research Track Lead Pete Kyle and CFP Academic Fellow Chester Spatt authored this FER statement released on June 29, 2010, a result of a discussion at FER's annual meeting on July 18-20, 2009 at Skamania Lodge in the Columbia River Gorge. Professors Kyle and Spatt, along with CFP Director Lemma Senbet, are members of The Financial Economists Roundtable, a group of senior financial economists, who have made significant contributions to the finance literature and seek to apply their knowledge to current policy debates.

Finance Professor Michael Faulkender discusses executive compensation on PBS Newshour

Response to Interagency Notice of Proposed Rulemaking: Incentive-Based Compensation Arrangement
by Ethan Cohen-Cole, Michael Faulkender, Nagpurnanand Prabhala, Lemma Senbet and Haluk Ünal
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On May 3, 2011, five CFP faculty associates sent a letter to several agencies responding to the Notice of Proposed Rulemaking (NPR): Incentive-Based Compensation Arrangement. The letter comments on the definition of covered institutions, incentive-based compensation, required reports, deferral arrangements, executive compensation, and personal hedging strategies of executives. The faculty associates provide recommendations that they feel will further strengthen the objective of this Interagency NPR, which is “to strengthen the incentive compensation practices at covered institutions by better aligning employee rewards with longer-term institutional objectives.”


Executive Compensation: An Overview of Research on Corporate Practices and Proposed Reforms
by Michael Faulkender, Dalida Kadyrzhanova, N. Prabhala, and Lemma Senbet
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Abstract: The 2008 financial crisis spread rapidly around the world. These landmark episodes have drawn attention to the high levels of executive compensation, and to the possibility that the structure of executive pay plans may have contributed to the post-1990s bubbles, corporate scandals, and recent financial crisis.

Inside Debt, Bank Default Risk and Performance during the Crisis
by Haluk Ünal
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Abstract: In this paper, we examine whether the structure of the chief executive officer’s (CEO) compensation package can explain default risk and performance in bank holding companies (BHCs) during the recent credit crisis. Using a sample of 371 BHCs, we show that in 2006 lower holdings of inside debt relative to equity by a CEO has an association with higher default risk and worse performance during the crisis period. We also show that inside debt is a better signal of the BHCs’ performance and default risk than inside equity measures. Finally, we provide evidence that supervisors issued favorable ratings to the lead bank in BHCs that paid their CEOs relatively higher inside debt.

Corporate Governance Mandates and Firm Outcomes
by CFP Academic Fellow Reena Aggarwal, Jason D. Schloetzer and Rohan Williamson
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Abstract: Regulators and stock exchanges have recently responded to perceived corporate governance failures by mandating certain governance attributes across all firms. There has been considerable debate whether this public policy approach achieves the desired goal even for firms that have the weakest governance structure and are most affected by the mandates. While SOX-related regulatory actions required all firms to adopt certain corporate governance attributes, not all firms were equally affected. This paper identifies a unique sample of firms that were more affected by the new corporate governance regulations compared with relatively less affected firms. Using a propensity-score trimmed sample, we find affected firms had significantly lower pre-regulation valuations. After affected firms adopt governance mandates, there is an increase in affected firm post-regulation firm value compared with relatively less affected firms. This relative increase for affected firms is not related to post regulation differences in investment, earnings quality, or operating performance. Rather, affected firms experience a decrease in CEO compensation and an increase in the likelihood of CEO turnover in the post-regulation period compared with relatively less affected firms. Overall, the evidence suggests that corporate governance mandates enhanced firm value and improved board monitoring of firms most affected by the regulatory action.

Concentrating on Governance
by Dalida Kadyrzhanova and Matthew Rhodes-Kropf
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Abstract: This paper develops a novel trade-off view of corporate governance. Using a simple model that integrates agency costs and bargaining benefits of management-friendly provisions, we identify the economic determinants of the resulting trade-offs for shareholder value. Consistent with the theory, our empirical analysis shows that provisions that allow managers to delay takeovers have a significant bargaining effect and a positive relation with shareholder value in concentrated industries. By contrast, non-delay provisions have an unambiguously negative relation with value, and more so in concentrated industries. Overall, our analysis suggests that there are governance trade-offs for shareholders and industry concentration is an important determinant of their severity.

Relative Governance
by Dalida Kadyrzhanova and Kose John
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Abstract: Using data on antitakeover provisions and headquarters location for a large sample of U.S. public corporations, this paper documents robust evidence of complementarity between firm-level and local corporate governance.

Is Disclosure an Effective Cleansing Mechanism? The Dynamics of Compensation Peer Benchmarking
by Michael Faulkender and Jun Yang
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Abstract: It has become a regular practice for firms to benchmark their executive compensation against peer companies. This paper examines the dynamics of the peer benchmarking process, addressing whether the 2006 regulatory requirement of disclosing compensation peers thereby casting sunshine on the practice has mitigated firms’ behavior of benchmarking CEO compensation against a group of self-selected, highly-paid peer CEOs (Faulkender and Yang, 2010; Bizjak, Lemmon, and Nguyen, 2011). Our evidence shows the gaming of the benchmarking process has actually been exacerbated since disclosure became mandatory in 2006, calling into question the ability of mere disclosure to remedy potential abuses in determining executive compensation.

Law, Organizational Form, and Taxes: Financial Crisis and Regulating through Incentives
by Kose John, Vinay B. Nair, Lemma Senbet
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Abstract: Calls for tighter financial regulation are gathering momentum in the wake of the global financial crisis. In a setting where corporate innovation imposes positive and negative externalities, the social impact of firms in the private sector depends on the sharing rule between their owners and the society at large. We examine the role of law, regulation and institutions in altering this sharing rule. We propose a framework where the social planner puts in place a system of laws, organizational forms, and taxation within which firms optimize without invasive regulation. Since the legal regime affects the extent to which owners of firms are held responsible for the negative externalities they impose, unlimited liability may discourage innovation in strong legal regimes. Limited liability, however, might be accompanied by excessive innovation. We highlight the role of the government in altering the sharing rule due to its claim through corporate taxation and investigate the relation between law and corporate taxation. We show that the equilibrium corporate tax rates are a decreasing function of legal effectiveness in the embedding economy. We also explore the policy implications of our results for the effectiveness of the mechanisms used in the bailout of failed institutions in the current financial crisis. Finally, we highlight some stylized facts from cross-country data that support our results.

Pay for Performance? CEO Compensation and Acquirer Returns in BHCs
by Haluk Unal, Kristina Minnick, Liu Yang
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Abstract: We examine how managerial incentives affect acquisition decisions in the banking industry. We find that higher pay-for-performance sensitivity (PPS) leads to value-enhancing acquisitions. Banks whose CEOs have higher PPS have significantly better abnormal stock returns around the acquisition announcements. On average, acquirers in the High-PPS group outperform their counterparts in the Low-PPS group by 1:4% in a three-day window around the announcement. Ex ante, higher PPS helps to prevent value-destroying acquisitions, while at the same time promote value-enhancing acquisitions. The positive market reaction can be rationalized by post-merger performance. Following acquisitions, banks with higher PPS experience greater improvement in their operating performance.

Offsetting Behavior and Compensation Reform
By N. Prabhala and N. K. Chidambaran
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Abstract: Calls for regulation and reform of compensation have intensified following the2008 financial crisis, as flawed compensation is implicated as a cause of the crisis. Our study illustrates a key difficulty in implementing reform through regulation: offsetting behavior, which can entirely undo regulatory intent and even impose additional costs on shareholders. We show these effects in the context of compensation contracts, using as a laboratory the punitive disclosure requirements imposed in 1998 to deter repricing. Firms demonstrate strong offsetting behavior by squeezing out compensation through a substitute, which is paradoxically costlier for shareholders. The excess costs are best explained by a wedge between employee and firm incentive valuations and we characterize its nature. We also find offsetting behavior in broader samples of all firms with underwater options after 1998. We discuss the implications for the design of compensation design and reforms likely to be most effective in curbing compensation excesses.

Agency Costs of Idiosyncratic Volatility, Corporate Governance, and Investment
by Dalida Kadyrzhanova and Kose John
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Abstract: This paper identifies a fundamental conflict of interest between managers and shareholders in risk taking decisions and explores its implications for the relation between external governance mechanisms, corporate investment, and value. Using a dynamic panel GMM estimator to address endogeneity, we show that antitakeover provisions (ATPs) lead to more conservative investment decisions, including relatively less investment in R&D, more investment in PPE, and more diversifying acquisitions, and that these effects are concentrated among high idiosyncratic volatility firms - i.e., firms with agency costs of idiosyncratic risk. In addition, we find that ATPs lead to large drops in firm value, and that this negative valuation effect of ATPs is also concentrated among high idiosyncratic volatility firms - i.e., the firms for which ATP-induced conservatism is more pronounced. These results suggest that ATPs lead to excess managerial conservatism. Thus, by curbing managers’ tendency to avoid value-enhancing risks, corporate governance reforms can create value for shareholders.

Optimal CEO Incentives and Industry Dynamics
by Dalida Kadyrzhanova and Antonio Falato
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Abstract: This paper develops a competitive equilibrium model of CEO compensation and industry dynamics. CEOs make product pricing and product improvement decisions subject to shareholders compensation choices and idiosyncratic shocks to product quality. The choice of high-powered incentives optimally trades-off the benefits from expected product improvements and the associated agency costs. In market equilibrium, the interaction between CEO pay and product market decisions affects the stationary distribution of firms. We characterize a dynamic feedback effect of industry structure on CEO incentives. As a result of this effect, we predict an inverse relation between the magnitude of the performance based component of CEO pay and, (i) across industries, the degree of heterogeneity of industry structure; (ii) within industries, firm position with respect to its peers. We empirically estimate pay-performance sensitivity for a large sample of U.S. CEOs and other top executives over the 1993 to 2004 period and find strong support for our theory. Our results offer a novel product market rationale for the increased reliance of CEO pay on bonuses and stock options over the 1990s.

A Theory of Preemptive Entrenchment
by Dalida Kadyrzhanova
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Abstract: Entrenchment can benefit shareholders since aggressive managers deter rivals and, thus, make competition softer in the product market. I formalize this intuition within a simple industry equilibrium model of optimal entrenchment and test its implications empirically. The key cross-sectional prediction of the model is that industry leaders benefit most from preemptive entrenchment, since they suffer relatively larger losses in market share from facing tougher competition. I find strong support for this prediction and a number of related cross-sectional implications of my model using a large sample of U.S. public firms between 1990 and 2005 and a wide variety of entrenchment measures, such as external (antitakeover provisions, state antitakeover laws) and internal (board size and independence, institutional shareholders and pension funds) governance. In particular, I find that (i) industry leaders are more entrenched than laggards; (ii) the valuation effect of entrenchment is negative for laggards, but positive for leaders. Moreover, the link between industry leadership and the valuation effect of entrenchment is more pronounced in industries that are more concentrated, relatively less heterogeneous, and less subject to foreign competition. These findings offer a novel perspective over the debate on whether governance creates value by documenting when that is actually the case.

The Impact of Networks on CEO Turnover, Appointment, and Compensation
by Yun Liu
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Abstract: This paper studies the influence of networks and connectedness on CEO labor market outcomes, including new CEO appointments, CEO termination, and CEO compensation. I distinguish between the pairwise specific CEO-board connectedness and the strength and structure of the CEO’s overall connectedness. I find that both types of connectedness add to traditional turnover and compensation variables in distinct and economically significant ways. Specific connectedness increases CEO entrenchment. Greater overall CEO connectedness on the employment network results in greater likelihood of CEO departure, greater turnover-performance sensitivity, and more rapid re-employment of a departed CEO. The existence of specific links between the CEO candidate and the board of directors enhances the chances of appointment in the event a company chooses to appoint an outsider as the CEO. Finally, CEOs with better overall connectedness enjoy higher total compensation. The evidence suggests that the general connectedness of a CEO in the employment network has significant and distinct economic effects beyond those of the connections between the CEO and the board in the current firm.

Monetary Policy and Capital Regulation in the US and Europe
by Ethan Cohen-Cole and Jonathan Morse
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Abstract: From the onset of the 2007-2009 crisis, the Federal Reserve and the European Central Bank have aggressively lowered interest rates.

Both sets of changes are at odds with an anti-inflationary stance of monetary policy; indeed, as the crisis began in August 2007 inflation expectations were high and rising, particularly in the United States. We have two additions to the literature. One, we present a model economy with a leveraged and regulated financial sector. Two, we find optimal Taylor rules for our economy that are consistent with a strong pro-inflationary reaction during financial crisis while maintaining a standard output-inflation mandate. We have three interpretations of our results. One, because the Federal Reserve has partial control over bank regulation it can exercise regulatory lenience. Two, the Fed’s stronger output orientation means that it will potentially respond more quickly when faced with constrained banks. Three, our results support pro-cyclical capital regulation.