Executive Stock Options and Risk-Taking Behavior in Banking

Introduction: Stock Options and Executive Compensation

General Overview

An issue arising within the public domain is that of executive compensation and its repercussions on society as a whole. Over the past three decades, executive compensation has ballooned while the average worker has continued to see only modest gains in income. This disproportionate disparity between executive compensation and that of the average American family provides a solid foundation for examining the merits of stock options.

The value of stock options now dwarfs the actual value returned to shareholders. In accordance with this growing executive demand for stock options, there has been a corresponding increase in academic literature on the subject. This literature presents interesting arguments both for and against stock options — arguments that are valid in regard to their overall claims. What is particularly interesting, in the context of prevailing economic conditions, is the question of whether stock options genuinely increase firm value, or whether they are simply a tool for the wealthy to accumulate more wealth without a corresponding increase in firm value.

This topic is of particular interest given the "Occupy Wall Street" movement and other anti-banking sentiments that developed over the preceding five years. Stock options have been at the forefront of these anti-banking sentiments as unemployment, wages, and home ownership decreased while large organizations continued to award stock options to their executives. This is particularly true of banking organizations, which the public perceived as having disproportionately caused the fiscal crisis of 2008. Others, however, believe stock options were needed precisely at that time so that executives had the incentive to correct the errors of their respective firms. These commentators believe that societal sentiments are misplaced and that more emphasis should be placed on individual decision-making regarding the crisis, rather than on stock options and compensation. Both arguments have merit and deserve consideration within the overall context of employee compensation.

This study evaluates whether stock options align with shareholder value. The fundamental argument here is that this alignment theory is flawed. In some respects, stock ownership does indeed align company goals with those of management and stockholders. In other instances, however, stock options encourage management to take excessive risks in order to temporarily inflate the value attributed to each share. This excessive behavior on the part of management is typically achieved through high-risk decisions at the firm level. Such higher risk, by virtue of the uncertainty inherent in it, can create the potential for devastating losses. When excessive leverage is added to the equation, companies once thought to be stable can instantly become insolvent — Bear Stearns, Long-Term Capital Management, Washington Mutual, and Lehman Brothers are prominent examples.

Numerous examples occurring primarily during the financial crisis support this argument. Bank of America's acquisition of Countrywide Financial was an extremely risky endeavor that cost shareholders nearly half the market valuation of their company. During the crisis, however, executives temporarily heightened the value of their stock. Long after their departure, shareholders were left with a significantly devalued company. Therefore, stock options that carry no potential for downside risk on the part of management encourage risky behavior that ultimately undermines shareholders' interests.

There is support in the research for the idea that corporations may not award stock options to executives in the most optimal fashion. New executives are likely to receive particularly large stock option awards, presumably because of the impact of executive decisions on firm value (Yermack, 1994). This is one of several variables that may influence the short-term orientation of executives toward their compensation. Another is that boards of directors are unlikely to pay substantive long-term compensation to executives as their retirement approaches (Yermack, 1994). Further, as firm size increases, it becomes more difficult for boards to monitor managerial performance directly, and fixed administrative costs for implementing compensation plans are generally incurred (Yermack, 1994). The relation between new stock option awards and the current performance of a firm is roughly zero, as the relevant coefficient is generally of very small magnitude (Yermack, 1994). At the time of Yermack's research in the early 1990s, the author concluded that "contingent pay instruments used in CEO compensation are not well designed to reduce agency costs and are not awarded with great sensitivity to firms' financial environments" (1994, p. 29).

Stock options, however, do have merit in regards to objective alignment when used appropriately. A stock option in a conservatively run company does indeed encourage value-enriching behavior, particularly if shareholders act as actual owners of the company and are therefore vulnerable to downside risk. Proper oversight in regards to acquisitions, mergers, and capital expenditures also increases the effectiveness of stock options.

Performance-Oriented Rewards with Particular Emphasis on Stock

Performance-oriented reward systems are most often directed at executive compensation and are used to align executive pay with the overall performance of a business unit or the firm. In performance-based systems, executive compensation in the form of salary adjustments, awards, and bonuses commonly shows a linear relationship to performance. Strong positive correlations between executive performance ratings and executive performance compensation in companies using a performance-based approach can typically be demonstrated through the Pearson correlation coefficient.

Stock options are used primarily to attract management talent when capital is not widely available. This is especially true for young, emerging companies that have little capital but wish to attract top talent. Through stock options, talented managers can be drawn to a company without requiring a large concrete salary. This is advantageous to both the firm and the individual manager. The firm obtains talent that can be used to grow the business, and the goals and objectives of the firm are aligned as the manager is compensated in stock options. The manager benefits as well, since if the role is conducted in a conservative manner, the value of his or her holdings can increase while the company is being built. In these scenarios, stock options provide a powerful tool for properly aligning the goals of management with those of the firm.

Options are not stock in physical form but rather a claim to stock at a predetermined price. Two key distinctions regarding this concept are important. First, stock options have an asymmetric payoff, and second, they do not pay dividends. Actual stock ownership does pay dividends. These two distinctions can create risk-taking behavior on the part of management because the value of options increases with the overall risk of the firm. The price of options also decreases with a large dividend increase. The more stable a company's performance, the less valuable the option will become. Performance-oriented rewards therefore provide incentive to increase firm risk while also producing a corresponding decrease in dividends. Overall dividends have decreased substantially relative to earnings in recent decades (Fama and French, 1999), though this may be a response to overall market risk rather than risk in any particular firm. Wayne Guay notes that firms with very high growth opportunities tend to increase the granting of stock options (Guay, 1999), and in turn, these option-holding managers take on more risk to increase the value of those options. This behavior, by virtue of the risk inherent in it, causes many smaller growth firms to become insolvent and eventually bankrupt.

Further complicating the question of performance-oriented rewards and their relevance to shareholders is the evidence regarding risk preferences. Is risk-taking on the part of management desirable or undesirable from a shareholder perspective? It is difficult to answer this question definitively when a shareholder population may consist of thousands of owners with differing preferences. Managers who shun risk may be overly conservative, taking fewer risks than are desired by shareholders (Lambert, Larcker, and Verrecchia, 1991). The principal-agent problem is compounded by managers who have strong incentive to avoid risk out of a desire to retain their positions. Conversely, there is also research providing strong incentive to encourage risk-taking through performance-oriented rewards. As such, it is difficult to determine unambiguously whether stock options encourage risky behavior, or whether such behavior is ultimately harmful to shareholders in the long run.

Research Question and Chapter Structure

This dissertation examines the link between stock options and the inherent risk of a company. Share options and risk, as noted above, are a growing concern as the economic recovery continues. Shareholders are now more cognizant of the substantial wealth accumulation and subsequent risk-taking on the part of executives. Many contend that the pay received by top-level executives is not commensurate with the value they create for the company (Touryalai, 2012).

Over the years, stock options have become an integral aspect of an executive's overall compensation. What once was simply an added bonus has now become the standard by which executives are compensated. It is through these stock options that the propensity to incur additional risk is exacerbated. This is particularly true for executives in industries deemed essential to the proper functioning of the economy. Executives in industries such as financial services, automotive, and energy are more prone to increased risk-taking due to the concept of moral hazard.

A moral hazard occurs when there is an incentive for a person to take high or unusual risks in an attempt to capture a profit while still possible — for example, before a contract is settled. As executives in these critical industries incur additional risk, there is seemingly no incentive to protect against the adverse economic consequences of their behavior. Since their industries are necessary for the overall economy to function, these executives assume that a third party — usually the government, taxpayers, or private enterprise — will absorb the loss. There is, therefore, a clear link between stock options and the riskiness of a firm's activities.

If moral hazard is present because risk is embedded in a company's strategy, the possibility of profound consequences increases dramatically. The key themes within this dissertation are attributed primarily to risk-taking on the part of executives who hold vast amounts of stock options. In addition to moral hazard, higher leverage ratios, negative NPV projects, and principal-agent complications all contribute to this risky behavior.

Due to the wide and varied discussion around stock options and overall risk-taking behavior, this document focuses on three core principles: the principal-agent problem, moral hazard, and asymmetric market information. These principles, more than any others, provide insights into stock options and risk-taking on the part of management. Both sides of the debate have valid examples, figures, and knowledge to reinforce their arguments. The document begins with this introduction, providing an overall synopsis of stock options, their prevalence, their appeal, and the unintended consequences of providing them. The literature review in Chapter 2 provides insights into the risk-taking behavior of management with large amounts of stock-based incentive compensation. Chapters 3 and 4 focus on the methodology and findings. Chapter 5 provides a critical analysis and conclusion.