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

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

Bizjak, Brickley and Coles [1993] argue that shareholders can motivate optimal investment by making managerial compensation more sensitive to long-run stock-price performance. By increasing the proportion of compensation based on stock returns, managers receive benefits from longer term investments even though they may leave the firm before these benefits are realized. Because compensation based on long-run stock-price performance controls the time horizon problem and because it provides incentives for optimal investment behavior, long-run stock price performance compensation may result in improved firm performance.

Problems Owners Face

Owners may face two negative aspects of manager performance. First, managers may "shirk" their responsibilities and over-consume perquisites, and second, as noted, they may be too conservative in their investment decisions. Compensation schemes are a deliberate attempt to modify managerial behavior to more closely conform to shareholders' objectives.

Shirking and Over-Consumption of Perquisites

An important instance of moral hazard arises in employment relationships, where employees may shirk their responsibilities. Evidence of the importance of moral hazard in the employment relationship is the frequency with which firms give employees incentive or performance contracts. These arrangements tie the employees' compensation to various measures of performance, and are meant to motivate effort, creativity, care, diligence, loyalty, and so on. One example is a bonus clause linking pay to firm profitability. When well-designed and well-administered, this sort of incentive arrangement can be effective in promoting the desired objective, shareholder wealth maximization. Although clear communication to employees of what it is the employer values is partly responsible for this effect, direct financial incentives are the key.

These arrangements contain an element of moral hazard-note that the firm is not paying directly for what the employees are supplying but instead uses a proxy for it. What is actually being supplied are such things as the employees' intellectual and physical effort. Profits and increased share prices are what is paid for, and they should reflect effort and ability. The amount and quality of the employees' efforts are difficult to monitor directly, whereas the results of their efforts may be more easily observed. Thus, rather than trying to pay for unobservable effort directly, the firm attempts to motivate employees to choose to work harder or better by rewarding outcomes that are more likely when they behave in the desired way.

Another problem arises in decentralization if a local manager with discretionary spending authority consumes an excessive amount of perquisites. For example, the manager may decide to improve his/her local working environment by acquiring a large, expensively decorated office space, by hiring an unnecessary large number of administrative assistants and support personnel, and by purchasing the latest and most elaborate office equipment. These expenditures will reduce the manager's performance measure, but the manager perhaps may prefer the direct consumption of these perquisites to the small increase in pecuniary compensation that could be earned by foregoing these expenditures.