Determinants Of The Use Of Financial Incentives

Determinants Of The Use Of Financial Incentives
A. The current problems in the financial markets, and the reasons why some investment banks have failed
The year 2008 has witnessed many aspects of a global financial crisis. The roots of this crises lie in events which started as early as 2000.The governments are now waking up to the damage caused by these events and trying to come up with solutions to salvage the situation.
The subprime mortgage crisis is an ongoing financial crisis, initially caused by individuals, businesses, and government entities that had borrowed and invested heavily in housing, followed by a significant decline in housing prices. This caused a ripple effect across the financial markets and global banking systems, as investments related to housing prices declined suddenly and significantly in value, placing the health of key financial institutions at risk.
This was followed by a liquidity cruch and institutions had to follow stricter guidelines for lending money to individuals. Bankers had anticipated a continuous growth in the property market, and loans had been disbursed to people with low credit worthiness to show a growth in the business.
Financial products called mortagage backed securities, had enabled financial institutions and investors around the world to invest in the U.S. housing market. Major banks and financial institutions reported losses of approximately US$435 billion as of 17 July 2008, as these securities derived their value from mortgage payments and housing prices.
As a result of this crisis, the most revered names on Wall Street have had to eat humble pie. In September 2008, Merrill Lynch agreed to sell itself on Sunday to Bank of America for roughly $50 billion to avert a deepening financial crisis. At almost the same time, while another prominent securities firm, Lehman Brothers, filed for bankruptcy protection, shocking the whole world. The collapse of Bear Sterns hedge funds is another example of the short sightedness of investment banking.
B. Theories about the use and reporting of executive compensation schemes, with investment banks as an example.
Controlling for CEO pay-performance sensitivity (delta) and the feedback effects of firm policy and risk on the managerial compensation scheme, it is observed that higher sensitivity of CEO wealth to stock volatility (vega) implements riskier policy choices, including relatively more investment in R&amp.D, less investment in PPE, more focus, and higher leverage. We also find that riskier policy choices generally lead to compensation structures with higher vega and lower delta. Stock-return volatility has a positive effect on both vega and delta.
C. How investment banks use and report executive compensation schemes
Quantitative analysis of a detailed industry-wide survey validates the hypothesis that those occupations where output is easily identifiable receive higher bonus pay. The proximity of an occupation to the revenue generating activity within the organisation is also found to be significant in determining bonus levels, as is job grade within the organisation.
CEOs are being recruited from all parts of the world, irrespective of their nationality in companies that want to surge ahead. Sound technical know-how, experience, skill and a marketing talent is all that is required to reach the top anywhere in the world.
D. What are the implications of disclosing the executive compensation schemes in the company’s accounts and reports for the long-term prospects?
Controlling for more CEO pay-performance sensitivity and the feedback effects of firm policy and risk on the managerial compensation scheme, we find that higher sensitivity of CEO wealth to stock volatility implements riskier policy choices, including more investment in R&amp.D, less investment in PPE, more focus and higher leverage.
The choice of payment as stock option allows executives to invest in riskier assets and implement more aggressive debt policy.
While the proponents of disclosure rule of CEOs adopted by SEC in 1992 feel that disclosing the stockholding of the CEO would increase shareholder confidence, its opponents feel that disclosure would only result in cosmetic changes, disseminate valuable information to competitors and increase reporting costs.
References
1. David Nash, Determinants of the use of financial incentives in investment banking
http://ideas.repec.org/p/cbr/cbrwps/wp256.html
2. http://en.wikipedia.org/wiki/Bear_Stearns
3. http://en.wikipedia.org/wiki/Subprime_mortgage_crisis