Management of loan loss reserves by commercial bankers--part 1

Journal of Bank Cost & Management Accounting, The, 1996 by Joyce, William B

Also, some managers may engage in an activity called empire building, which attempts to increase the size of the organization they are managing. The non-pecuniary rewards from empire building include the increased power and prestige associated with managing a larger organization. If the managers' compensation of promotion probability is an increasing function of the size of the units they are managing, these non-pecuniary factors could become pecuniary.

The Under-Investment Problem

Managers are responsible not only for day-to-day operations but also longer-term investment. Managers then have the ability to affect future cash flows via their selection of investments. A problem with bonus plans based on earnings or earnings growth is that they can distort investment decisions. Positive net present value projects may lose money during their gestation phase. If managers' compensation is based on short-term profits objectives, as many bonus plans are, they may decide to under-invest (in order to increase short-term profits). In an effort to modify bonus plans to provide incentives to adopt longer horizons, firms have developed bonus plans based on moving averages of 3 to 7 years of profits [Kamm (1978)]. While this longer horizon is an improvement, there remains the problems that the bonus is still typically based on accounting measures of income (that may or may not have a direct correspondence with shareholder wealth creation) and that future profits are not included in this calculation. Management whose compensation is based on straight salary cannot benefit from undertaking risky positive net present value projects unless their salaries are adjusted ex post to reflect good decisions. Stock option plans are another way to correct this incentive to under-invest because the options and the stock are immediately more valuable when risky positive net present value projects are initiated. However, there are several possible drawbacks. Management cannot easily diversify the greater firmspecific risk imposed by stock option plans, and they may require a higher expected level of compensation. From the shareholders' point of view, the cost of the higher expected compensation partially offsets benefits of reducing the under-investment problem. In addition, stock options are not protected against dividend payments. This could produce reluctance in management to propose dividend increases when they may otherwise be warranted. Shareholders may view this as an additional cost. Finally, if the managers increase the firm's financial leverage, the resulting increase in the variability of the stock will increase the value of management's stock options. Yet, this increased variability of stock price may actually reduce the stock's value.

Agency Costs

To ensure that its managers act in the best interests of all outside shareholders, the bank must incur agency costs, which take several forms: (1) expenditures to monitor managerial actions, (2) expenditures to structure the organization so that the possibility of undesirable managerial behavior will be limited, and (3) opportunity costs associated with lost profit opportunities resulting in an organizational structure which does not permit managers to take actions on as timely a basis as would be possible if the managers were also the owners.