February 19, 2013

Executive Options and Worried Bankers

University of Nebraska-Lincoln Associate Professor of Finance Emre Unlu and colleagues study what bankers do to ensure that risk-seeking CEOs do not gamble with bankers’ funds.

Through the use of managerial stock options in the CEO’s compensation package, boards incentivize CEOs to take risk so that profitable but risky business opportunities are not rejected by cautious managers. However, the firm’s creditors (banks, bondholders or other lenders) do not appreciate such risk-seeking incentives because creditors do not share the firm’s profits and might even be required to absorb the firm’s losses in case of bankruptcy.

Unlu and his colleagues study how lending is facilitated when the borrowing firm’s CEO has risk-seeking incentives induced by a compensation package. Unlu describes the motivation of the study as: “Option compensation is quite common among publicly traded corporations and corporations also carry billions of dollars in debt. We are interested in how creditors ensure that risk-seeking CEOs do not gamble with creditors’ funds.” More specifically, he examined whether creditors lend funds to such risk-seeking firms on a short-term basis.

“Lending funds on short maturity is a valuable tool for creditors to monitor management because every time the loan is due the firm will have to convince creditors that the firm will pursue investments with acceptable risk levels so that creditors extend the loan’s maturity-or rollover the loan,” Unlu said.

Consistent with their expectations, they found that firms with risk-seeking CEOs generally carry short term loans. In addition, they show that creditors charge higher interest rates when CEOs are incentivized to take risk and this higher cost of funding increases even further if the risk-seeking firm attempts to borrow on a long-term basis.

The study sheds light on creditors’ assessment of managerial incentives and risk-seeking behavior. The evidence supports the view that creditors do care about the executive compensation packages and do take the necessary precautionary measures to protect their interests.

Findings of this study might have implications for future policy making. “Company boards should be careful when designing executive compensation packages since risk-seeking incentives – while potentially benefiting shareholders – might constrict debt financing opportunities of the firm. Moreover, board oversight on compensation- leverage-maturity relationship is especially critical due to the role of excessive leverage in the recent financial crisis” Unlu said.

The study was published in the Journal of Finance in 2010. Coauthors of the study include Paul Brockman of Lehigh University and Xiumin Martin of Washington University in St. Louis.

Research abstract located at http://digitalcommons.unl.edu/financefacpub/21/