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

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

Jensen and Meckling demonstrate that a potential agency problem arises whenever the managers of a firm own less than 100 percent of the firm's common stock. If a bank is a proprietorship managed by the owner, it can be assumed that the owner-manager will take every possible action to improve his or her own welfare, with welfare measured primarily in the form of increased personal wealth but also in more leisure or perquisites, such as luxurious offices, use of a corporate plane and yachts, and personal assistants. However, if the owner-manager relinquishes a portion of his or her ownership by incorporating and selling some of the bank's stock to outsiders, a potential conflict of interest immediately arises. For example, the owner-manager may now decide to lead a more relaxed life and not work as strenuously to maximize shareholders' wealth because less of this wealth will go to him or her; or the owner-manager could take a higher salary or consume more perquisites because part of these costs will now fall on the outside stockholders. This potential conflict which arises any time managers are not sole owners is one type of agency problem. There are many others. Those most important to this work are discussed below.

Problems Managers Face Human Capital Risk

Human capital is an asset that is essentially non-transferable; so unless the manager has considerable other wealth, there is little hope of diversifying away the risks attached to it. When managers undertake a risky investment, they put their human capital at risk. The success or failure of the investment is likely to reflect on the managers who proposed and oversaw it, affecting (current and potential) employers' estimates of their ability. A good outcome may help their reputations and increase their future earnings potential. However, a bad outcome will be attributed, at least partly, to the managers' talents (or lack thereof) rather than entirely to random bad luck. If the project performs poorly, future salaries, jobs, and promotions may be endangered. Thus, even if pay is not directly and explicitly linked to performance of the investments for which a manager is responsible, the market mechanism may create such a linkage.

Again, without some incentive for taking risk, managers may sensibly be reluctant to put the value of their human capital at risk; career concerns will make managers risk averse about corporate investments. Thus, it may be necessary to devise special incentive plans to induce desirable risk taking. The Horizon Problem

Still another agency problem is that management and stockholders have different planning horizons. Managers face a finite time horizon equal to the length of their careers. On the other hand, stockholders are concerned with the changes in the value of stock. Because the stock's value reflects the discounted value of future cash flows, stockholders' effective horizons are infinite.

Gibbons and Murphy [1992] describe the horizon problem in terms of how compensation policy affects investment. Investment decisions require executives to trade off current expenditures against future revenues. If the revenues extend too far into the future, managers responsible for undertaking the project may have left the firm before all revenues are realized. Thus, managers have an incentive to avoid long-lived projects. Also according to Bizjak, Brickley and Coles [1993], managers have incentives to manipulate the accounting earnings if the compensation plan places heavy emphasis on accounting earnings. The result of this short-term behavior may result in either under-investment or over-investment. An optimal compensation package provides incentives for managers to undertake all profitable projects, even if the profits are realized after the manager has left.