Does CDS trading affect risk-taking incentives in managerial compensation?

Abstract

We find that managers receive more risk-taking incentives in their compensation packages once their firms are referenced by credit default swap (CDS) trading, particularly when institutional ownership is high and when firms are in financial distress. These findings provide suggestive evidence that boards offer pay packages that encourage greater risk taking to take advantage of the reduced creditor monitoring after CDS introduction. Further, we show that the onset of CDS trading attenuates the effect of vega on leverage, consistent with the threat of exacting creditors restraining managerial risk appetite.

CDS contract initiations: REIT board monitoring and corporate decision outcomes

“…In terms of long‐term incentive compensation, the coefficient on the CDS indicator variable is positive and statistically significant in Column 3 of Table 3, where the dependent variable is Lnoptions. The results are consistent with Chen et al (2019). Our results differ from the arguments of Dong et al (2017).…”

“…Colonnello (2016) shows that CDS firms reduce managerial risk‐taking incentives while increasing managerial wealth‐performance sensitivity, board independence, and CEO turnover performance sensitivity. Chen et al (2019) show that managers receive more risk‐taking incentives in their compensation packages. We argue that no consensus has emerged in this area largely because it has proven difficult to control for the non‐CDS determinants of CEO compensation, investments, and governance (e.g., risk or cross‐industry factors).…”

“…Furthermore, CDS contracts offer protection by limiting the downside risk of creditors while providing them with greater bargaining power (Bolton & Oehmke, 2011). Hence, Chen et al (2019) argue that reduced creditor monitoring may provide borrowing firms with more opportunities to increase risk-taking incentives in compensation to better align managerial incentives with shareholder interests.…”

Credit Default Swaps, Agency Problems, and Management Incentives

“…Our paper, which is mainly focused on a theoretical model of agency problems related to CDS, complements two recent empirical studies of the topic, Colonnello (2017) and Chen, Leung, Song, and Avino (2017). These papers focus on the implications of reduced creditor monitoring after the inception of CDS, which is one of the two agency problems that we highlight in our model (the other agency problem, overlooked in these two papers, is related to the reduced opportunity for strategic default).…”

Judging the True Health of Finance Institutions Based on Risk Behavior and Operation Performance

“…For example, Haisley et al [15] propose risky allocation in the combination and experience sampling conditions, which is mediated by three indicators-decreased risk perception, increased confdence in the risky fund, and a lower estimation of the probability of a loss. Chen et al [16] believe that risk behavior has a profound impact on credit default, and a reasonable risk behavior helps reduce credit risk and fnancial leverage; Caselli et al [17] conclude that the lower risk behavior and the degree of ownership diversifcation will be higher and the impact of exogenous monetary policy on the probability of institution default will be lower; Kanga et al [18] put forward that bank risk behavior is likely to refect the integration of the management team risk behavior; the article shows that controlling the bank macro risk behavior is the diversifcation of institution system indirectly, and risk behavior of each staf will be well controlled, such as [19][20][21] gives similar conclusions. However, institutional risk behavior is dynamically changing.…”