Success and Failure in Business
Compensation Benchmarking, Leapfrogs, and the Surge in Executive Pay
Thomas DiPrete, Greg Eirich & Matthew Pittinsky
American Journal of Sociology, forthcoming
Abstract:
Rising inequality in the American income distribution has been fueled in recent years by surging incomes in elite occupations, with the most prominent example being the compensation of American CEOs. Scholars argue whether CEOs are efficiently compensated by the mechanisms inherent in superstar markets, or whether their high pay constitutes "rent-extraction" made possible by a failure of corporate governance. Paradoxically, while both explanations typically treat firms as atomistic actors, the principal mechanism used to determine and control high CEO pay is benchmarking against peer groups. As such, we propose a third explanation that focuses on the reinforcing impact of cognitively and rhetorically constructed compensation networks and the behavior of "leapfroggers," those few CEOs in a year who manage to jump to the upper tail of benchmark pay distributions. Counterfactual simulation based on Standard and Poor's ExecuComp data on executive compensation demonstrates that the effects of leapfrogging spread through the distribution and potentially explain a considerable fraction of the overall upward movement of executive compensation over a recent 15 year period.
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Does Algorithmic Trading Improve Liquidity?
Terrence Hendershott, Charles Jones & Albert Menkveld
Journal of Finance, forthcoming
Abstract:
Algorithmic trading has sharply increased over the past decade. Does it improve market quality, and should it be encouraged? We provide the first analysis of this question. The NYSE automated quote dissemination in 2003, and we use this change in market structure that increases algorithmic trading as an exogenous instrument to measure the causal effect of algorithmic trading on liquidity. For large stocks in particular, algorithmic trading narrows spreads, reduces adverse selection, and reduces trade-related price discovery. The findings indicate that algorithmic trading improves liquidity and enhances the informativeness of quotes.
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Risk and the CEO Market: Why Do Some Large Firms Hire Highly-Paid, Low-Talent CEOs?
Alex Edmans & Xavier Gabaix
NBER Working Paper, May 2010
Abstract:
This paper presents a market equilibrium model of CEO assignment, pay and incentives under risk aversion and heterogeneous moral hazard. Each of the three outcomes can be summarized by a single closed-form equation. In assignment models without moral hazard, allocation depends only on firm size and the equilibrium is efficient. Here, talent assignment is distorted by the agency problem as firms involving higher risk or disutility choose less talented CEOs. Such firms also pay higher salaries in the cross-section, but economy-wide increases in risk or the disutility of being a CEO (e.g. due to regulation) do not affect pay. The strength of incentives depends only on the disutility of effort and is independent of risk and risk aversion. If the CEO affects the volatility as well as mean of firm returns, incentives rise and are increasing in risk and risk aversion. We calibrate the efficiency losses from various forms of poor corporate governance, such as failures in monitoring and inefficiencies in CEO assignment. The losses from misallocation of talent are orders of magnitude higher than from inefficient risk-sharing.
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What's All That (Strategic) Noise? Anticipatory Impression Management in CEO Succession
Scott Graffin, Mason Carpenter & Steven Boivie
Strategic Management Journal, forthcoming
Abstract:
We develop and test a novel theory about strategic noise with regard to CEO appointments. Strategic noise is an anticipatory and preemptive form of impression management. At the time it announces a new CEO, a board of directors seeks to manage stakeholder impressions by at the same time releasing confounding information about other significant events. Several CEO and firm characteristics affect the likelihood that this will happen. Strategic noise is most likely for very long-term CEOs with a wide pay gap between other top managers at high stock price performance firms, and when a new CEO does not have previous CEO experience or comes from a less well-regarded firm. Results showing that CEO succession announcements are noisier than they would be by chance have some interesting implications for impression management theory, traditional event study methodology, and managerial and public policy. Interviews with public firm directors on CEO succession provide additional validity for the strategic noise construct and help us to articulate key elements of the theory.
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Anna Cianci & Steven Kaplan
Accounting, Organizations and Society, May 2010, Pages 478-495
Abstract:
Two experiments are conducted in which MBA students make judgments about a company's future performance and management's reputation after the company reports poor financial results. Information about the CEO's pre-existing reputation is manipulated at three levels (favorable, unfavorable, or none) and the plausibility of management's explanation is manipulated at two levels (plausible or implausible). Generally, the results indicate that management's explanations influence investors' judgments of the company's future performance and that judgments about management were jointly influenced by both manipulated factors. Specifically, our results indicate that a pre-existing favorable management reputation is an enduring trait that is not damaged even when management offers an implausible explanation. Our results are consistent with Mercer (2004) but inconsistent with other research ([Janoff-Bulman, 1992] and [Meyerson et al., 1996]) suggesting that a good reputation is easily lost. Our results also indicate that offering a plausible explanation improves the reputation of managers with an unfavorable reputation. We also find that judgments about management's intentions for explaining poor performance represent a partial mediator for judgments about management's reputation. Finally, we provide evidence that judgments about the company's future performance and management's reputation are consequential in that they are associated with investors' equity judgments.
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The Consequences of Entrepreneurial Finance: A Regression Discontinuity Analysis
William Kerr, Josh Lerner & Antoinette Schoar
NBER Working Paper, March 2010
Abstract:
This paper documents the role of angel funding for the growth, survival, and access to follow-on funding of high-growth start-up firms. We use a regression discontinuity approach to control for unobserved heterogeneity between firms that obtain funding and those that do not. This technique exploits that a small change in the collective interest levels of the angels can lead to a discrete change in the probability of funding for otherwise comparable ventures. We first show that angel funding is positively correlated with higher survival, additional fundraising outside the angel group, and faster growth measured through growth in web site traffic. The improvements typically range between 30% and 50%. When using the regression discontinuity approach, we still find a strong, positive effect of angel funding on the survival and growth of ventures, but not on access to additional financing. Overall, the results suggest that the bundle of inputs that angel investors provide have a large and significant impact on the success and survival of start-up ventures.
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Star power: Colleague quality and turnover
Boris Groysberg & Linda-Eling Lee
Industrial and Corporate Change, June 2010, Pages 741-765
Abstract:
In this article, we argue that the existence of greater organizational resources, in the form of higher quality colleagues, acts as a retention mechanism. We test our hypotheses using a panel data set of securities analysts in 24 securities firms over a 9-year period. Results show that analysts working with higher quality colleagues are less likely to turnover. Analyst turnover is affected by the performance of two types of colleagues: colleagues within one's group and colleagues in the client-facing role. This "colleague effect" applies to analyst turnover to competitor firms and not to analysts who exit the securities analysts industry.
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The Causal Impact of Media in Financial Markets
Joseph Engelberg & Christopher Parsons
University of North Carolina Working Paper, October 2009
Abstract:
It is challenging to disentangle the causal impact of media reporting from the impact of the information being reported. We solve this problem by comparing the behaviors of investors with access to different media coverage of the same information event. First, we use zip codes to identify 19 mutually exclusive trading regions, corresponding to 19 large U.S. cities and local newspapers (e.g., the Houston Chronicle). For all earnings announcements of S&P 500 Index firms, we find that local media coverage strongly predicts local trading, after controlling for characteristics of the earnings surprise, firm, local investors, and reporting newspaper(s). Reverse causation does not explain our findings. The local coverage-local trading effect: 1) holds for firms unlikely to be of local interest (e.g., remotely located, sparsely held by local investors) and 2) disappears entirely during extreme weather events, which leaves media content unchanged, but disrupts transmission to investors. The evidence supports the idea that media -- apart from the information they transmit -- affect investor behavior.
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Did Bankruptcy Reform Cause Mortgage Default to Rise?
Wenli Li, Michelle White & Ning Zhu
NBER Working Paper, May 2010
Abstract:
This paper argues that the U.S. bankruptcy reform of 2005 played an important role in the mortgage crisis and the current recession. When debtors file for bankruptcy, credit card debt and other types of debt are discharged-thus loosening debtors' budget constraints. Homeowners in financial distress can therefore use bankruptcy to avoid losing their homes, since filing allows them to shift funds from paying other debts to paying their mortgages. But a major reform of U.S. bankruptcy law in 2005 raised the cost of filing and reduced the amount of debt that is discharged. We argue that an unintended consequence of the reform was to cause mortgage default rates to rise. We estimate a hazard model to test whether the 2005 bankruptcy reform caused mortgage defaults to rise, using a large dataset of individual mortgages. Our major result is that prime and subprime mortgage default rates rose by 14% and 16%, respectively, after bankruptcy reform. We also use difference-in-difference to examine the effects of three provisions of bankruptcy reform that particularly harmed homeowners with high incomes and/or high assets and find that the default rates of affected homeowners rose even more. We find that bankruptcy reform caused the number of mortgage defaults to increase by around 200,000 per year even before the start of the financial crisis, suggesting that the reform increased the severity of the crisis when it came.
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Walking Away: The Emotional Drivers of Strategic Default
Brent White
University of Arizona Working Paper, May 2010
Abstract:
An increasingly influential view is that strategic defaulters make a rational choice to default because they have substantial negative equity. This article, which is based upon the personal accounts of over 350 individuals, argues that this depiction of strategic defaulters as rational actors is woefully incomplete. Negative equity alone does not drive many strategic defaulters' decisions to intentionally stop paying their mortgages. Rather, their decisions to default are driven primarily by emotion - typically anxiety and hopelessness about their financial futures and anger at their lenders' and the government's unwillingness to help. If the government and the mortgage industry wish to stem the tide of strategic default, they must address these emotions. Because emotions are primary, however, principal reductions may not be necessary. Rather, many underwater homeowners simply need some reason to feel less apprehensive about the financial consequences of continuing to pay their underwater mortgages. One possible way to provide this comfort would be a "rent-based loan program," allowing underwater homeowners to refinance their entire balances to an interest rate that would bring their mortgage payment in line with the rental cost of a comparable home. Indeed, a rent-based approach would relieve many underwater homeowners' financial anxiety and likely be enough alone to stem the tide of strategic default.
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Financial Development and City Growth: Evidence from Northeastern American Cities, 1790-1870
Howard Bodenhorn & David Cuberes
NBER Working Paper, May 2010
Abstract:
Using cross sectional and panel techniques, we find a positive and strong correlation between financial development and subsequent city growth in the Northeastern United States between 1790 and 1870. The correlation is robust to controls for geographical characteristics of the city, the percentage of population working in different sectors, and its initial population. This positive association is still significant when we control for sample selection. Propensity score matching estimators that compare similar cities in terms of observables and Heckman models that control for unobservables also yield a positive association between finance and urban growth. Our estimates suggest that the presence of a bank at a given location increases its subsequent growth by one to two percentage points per year. Because urban growth was correlated with economic development in the nineteenth-century US, we believe our results provide further support for the finance-growth nexus.