Incentivizing Calculated Risk‐Taking: Evidence from an Experiment with Commercial Bank Loan Officers

We conduct an experiment with commercial bank loan officers to test how performance compensation affects risk assessment and lending. High‐powered incentives lead to greater screening effort and more profitable lending decisions. This effect is muted, however, by deferred compensation and limited liability, two standard features of loan officer compensation contracts. We find that career concerns and personality traits affect loan officer behavior, but show that the response to incentives does not vary with traits such as risk‐aversion, optimism, or overconfidence. Finally, we present evidence that incentives distort the assessment of credit risk, even among professionals with many years of experience.     

Delegation and incentives

This article analyzes the relation between authority and incentives. It extends the standard principal‐agent model by a project selection stage in which the principal can either delegate the choice of project to the agent or keep the authority. The agent's subsequent choice of effort depends both on monetary incentives and the selected project. We find that the consideration of effort incentives makes the principal less likely to delegate the authority over projects to the agent. In fact, if the agent is protected by limited liability, delegation is never optimal.     

The quiet return of equalization alongside incentive in the English local government finance system

Local authority retention of 50% of business rates revenue was introduced in England in 2013–14, to be increased to 100% in the next few years. This signalled a move away from formula-based grant funding towards a funding system based on economic incentives. However, the 2016–17 settlement includes adjustments that indicate that equalization imperatives remain part of the policy toolkit. Given the complexity of the influences on local authority funding, these could maintain a considerable role when the new system is introduced.     

A Case for Percentage Commission Contracts: The Impact of a “Race” Among Agents

In standard principal-agent problems, the issue at hand is how to align the interests of the agent with those of her principal. A commonly used contract involves the principal paying the agent a percentage of the sale price as commission. With respect to real estate brokerage contracts, it has been argued that percentage commission contracts fail to provide sufficient incentives to the agent. This paper re-evaluates the standard solution to a one seller, one agent agency problem by introducing more than one agent. It is shown that percentage commission contracts can induce first-best effort levels from agents. The result is due to the negative externalities created by the winner-takes-all race among agents. The optimal commission rates in this model are inconsistent, however, with the observed uniformity in commission rates across markets in the USA.     

Relational contracting and endogenous formation of teamwork

We study a relational contracting model with two agents where each agent faces multiple tasks: effort toward the agent's own project and helping effort toward another agent's project. We show that the optimal task structure is either specialization without help or teamwork with a substantial amount of help: teamwork with a small amount of help is never optimal. Specialization with high‐powered incentives can be implemented by relative performance evaluation. However, under teamwork, the evaluation scheme must be substantially different to overcome the multitasking problem. Consequently, a small amount of help is dominated by specialization with high powered incentives.     

Investing in a relationship

A principal can make an investment anticipating a repeated relationship with an agent, but the agent may appropriate the returns through ex post bargaining. I study how this holdup problem and efficiency depend on the contracting environment. When investment returns are observable, informal contracts ex post can be more efficient than formal contracts, as they induce higher investment ex ante: the principal invests not only to generate direct returns, but also to improve relational incentives. Unobservability of returns increases the principal's ability to appropriate the returns but reduces her ability to improve incentives. The optimal information structure depends on bargaining power.     

Negotiating contract types and contract clauses in the German construction industry during the Third Reich

This article examines the determinants of contractual form and renegotiations in the German construction industry during the Third Reich. At the beginning of World War II, firms dealt with growing uncertainty by convincing procurement agencies either to use cost‐plus contracts or to include an additional risk premium in fixed‐price contracts. In the later years of the war, procurement agencies initiated renegotiations over contract clauses to reduce the extraordinary profits resulting from information rents and high‐risk premiums. This regulatory course undermined the credibility of the regulatory commitment, thereby weakening the incentives of the fixed‐price contracts still in use.     

Contracting for information under imperfect commitment

We study optimal contracting under imperfect commitment in a model with an uninformed principal and an informed agent. The principal can commit to pay the agent for his advice but retains decision‐making authority. Under an optimal contract, the principal should (i) never induce the agent to fully reveal what he knows—even though this is feasible—and (ii) never pay the agent for imprecise information. We compare optimal contracts under imperfect commitment to those under full commitment as well as to delegation schemes. We find that gains from contracting are greatest when the divergence in the preferences of the principal and the agent is moderate.     

Optimal job design in the presence of implicit contracts

We characterize the optimal job design in a multitasking environment when the firms use implicit contracts (i.e., bonus payments). Two natural forms of job design are compared: (i) individual assignment, where each agent is assigned to a particular job and (ii) team assignment, where a group of agents share responsibility for a job and are jointly accountable for its outcome. Team assignment mitigates the multitasking problem but may weaken the implicit contracts. The optimal job design follows a cutoff rule where only the firms with high reputation concerns opt for team assignment. However, the cutoff rule need not hold if the firm can combine implicit incentives with explicit pay‐per‐performance contracts.     

Relational contracts with subjective peer evaluations

We study optimal dynamic contracting for a firm with multiple workers where compensation is based on public performance signals and privately reported peer evaluations. We show that if evaluation and effort provision are done by different workers (e.g., consider supervisor‐agent hierarchy), first‐best can be achieved even in a static setting. However, if each worker both exerts effort and reports peer evaluations (e.g., consider team setting), effort incentives cannot be decoupled from truth‐telling incentives. This makes the optimal static contract inefficient. Relational contracts based on public signals increase efficiency. Interestingly, the optimal contract may ignore signals that are informative about effort.     

A Pricing Model for Residential Homes with Poisson Arrivals and a Sales Deadline

We introduce a pricing model for single-family residences on the real estate market. The model considers purchase offers that arrive according to a Poisson process. The homeowner’s problem is to set a price that will maximize his net profit. The selling agent suggests a price to the homeowner that will maximize her net profit, which consists of her sales commission minus her costs. Our model accounts for a deadline to sell the home, a common feature of the housing market, beyond which fixed and variable penalty costs accrue to both the homeowner and selling agent. We demonstrate the behavior of the model and show under what conditions the owner’s and agent’s incentives are aligned. Our computational results suggest, in most circumstances, that agents should not pressure owners to substantially lower their asking prices in the presence of a deadline.     

Funding conditions and insurance stock returns: Do insurance stocks really benefit from rising interest rate regimes?

We examine funding conditions and U.S. insurance company stock returns. Although constrained funding conditions, signaled by restrictive Federal Reserve monetary policy, correspond with increases in the future payouts of fixed‐income securities held by insurance firms and potentially provide value through the liability side of insurer balance sheets, they also decrease the values of securities currently held in insurer portfolios. Prior research finds that restrictive policy has a negative effect on equity returns in general. Our results suggest the negative impacts of constrained funding environments outweigh the potential positives, as insurance company stock returns are significantly lower during periods of constrained funding. This effect varies within a given funding state and also across insurer type. The effect is strongest during the first 3 months of a constrained funding environment and for life and health insurers—insurer types with longer portfolio durations. For property and liability (P&L) insurers, lower stock return performance only exists in the first 3 months of a constrained funding environment. In the subsequent months, P&L insurers actually have higher stock returns during constrained periods, consistent with their typically shorter duration asset portfolios, which are more quickly rolled over into new higher‐yielding securities.     

Lower Salaries and No Options? On the Optimal Structure of Executive Pay

We calibrate the standard principal–agent model with constant relative risk aversion and lognormal stock prices to a sample of 598 U.S. CEOs. We show that this model predicts that most CEOs should not hold any stock options. Instead, CEOs should have lower base salaries and receive additional shares in their companies; many would be required to purchase additional stock in their companies. These contracts would reduce average compensation costs by 20% while providing the same incentives and the same utility to CEOs. We conclude that the standard principal–agent model typically used in the literature cannot rationalize observed contracts.     

A market model with medium/long-term effects due to an insider

In this article, we consider a modification of the Karatzas–Pikovsky model of insider trading. Specifically, we suppose that the insider agent influences the long/medium-term evolution of Black–Scholes type model through the drift of the stochastic differential equation. We say that the insider agent is using a portfolio leading to a partial equilibrium if the following three properties are satisfied: (a) the portfolio used by the insider leads to a stock price which is a semimartingale under his/her own filtration and his/her own filtration enlarged with the final price; (b) the portfolio used by the insider is optimal in the sense that it maximises the logarithmic utility for the insider when his/her filtration is fixed; and (c) the optimal logarithmic utility in (b) is finite. We give sufficient conditions for the existence of a partial equilibrium and show in some explicit models how to apply these general results.     

The effect of fiscal stress and balanced budget requirements on the funding and measurement of state pension obligations

We examine the extent to which fiscal stress and state balanced budget restrictions affect the funding of state public employee retirement systems. Our results indicate a negative relation between pension funding levels and measures of both: (a) state fiscal stress and (b) the existence of balanced budget requirements. Our finding that fiscally stressed states meet balanced budget requirements through reduced funding of pensions raises public policy concerns over the fiscal integrity of employee pension funds in the public sector and the effectiveness of balanced budget requirements. Additionally, we find evidence that choice of pension discount rate is associated with states’ fiscal condition and the requirement to balance the budget. Our findings are consistent with the proposition that fiscally stressed states that are required to balance their budgets both underfund their pensions and select discount rates which obscure the underfunding.     

CEO Incentives,Relationship Lending,and the Cost of Corporate Borrowing

We investigate how lending relationships attenuate the conflict of interest between creditors and shareholders that arises from chief executive officer (CEO) compensation contracts. We find that lending relationships mitigate the influence of CEO risk‐taking incentives on loan spreads, especially for informationally opaque firms. In addition, lending relationships attenuate the impact of CEO risk‐taking incentives on maturity and collateral requirements. This article highlights the importance of bank monitoring through lending relationships to mitigate managerial risk‐shifting activities that arise from equity incentives.     

Sustaining implicit contracts when agents have career concerns: the role of information disclosure

Firms often augment career concerns incentives with implicit incentive contracts. I formalize the interaction between these two incentives, and highlight its implications on a firm's decision to disclose its workers' productivity information. Disclosure enhances career concerns but inhibits implicit contracts. I show two main results. First, implicit contracts weaken (i.e., substitute) career concerns if the prior belief about the worker's ability is low, and vice versa. Second, when these incentives are substitutes, the optimal disclosure policy follows a cutoff rule: patient firms are opaque, and transparent firms never offer implicit contracts. These results need not hold if the incentives are complements.     

Standard promotion practices versus up‐or‐out contracts

This article develops a theory concerning the choice between standard promotion practices and up‐or‐out contracts. Our theory is based on asymmetric learning and promotion incentives. We find that firms employ up‐or‐out contracts when firm‐specific human capital is low and standard promotion practices when it is high. We also find that, if commitment to a wage floor is feasible and effort provision is important, up‐or‐out is employed when low‐ and high‐level jobs are similar. These results are consistent with many of the settings in which up‐or‐out is typically observed, such as law firms and academia.     

Do Portfolio Manager Contracts Contract Portfolio Management?

Most mutual fund managers have performance‐based contracts. Our theory predicts that mutual fund managers with asymmetric contracts and mid‐year performance close to their announced benchmark increase their portfolio risk in the second part of the year. As predicted by our theory, performance deviation from the benchmark decreases risk‐shifting only for managers with performance contracts. Deviation from the benchmark dominates incentives from the flow‐performance relation, suggesting that risk‐shifting is motivated more by management contracts than by a tournament to capture flows.     

Leadership based on asymmetric information

Rational players, unconstrained by contracts or formal authority, choose to follow a better‐informed leader, whose action reveals part of her information. If the leader satisfies a credibility condition, then the unique nondegenerate equilibrium solves distinct shirking and coordination problems and achieves the first best. If credibility fails, as is more likely for a large organization, then followers ignore the leader, and equilibria are very inefficient. Appointing multiple leaders, or a high‐cost leader, can restore credibility. If players invest privately in information, then a leader often appears endogenously. The equilibrium concept is an original extension of sequential equilibrium to continuous states.