Wednesday, February 2, 2011

CFOs versus CEOs: Equity Incentives and Crashes

By Kim Jeong-Bon, Yinghua Li, and Liandong Zhang @ HLS Forum.

Using a large sample of U.S. firms for the period 1993-2009, we provide evidence that the sensitivity of a chief financial officer’s (CFO) option portfolio value to stock price is significantly and positively related to the firm’s future stock price crash risk. In contrast, we find only weak evidence of the positive impact of chief executive officer option sensitivity on crash risk. Finally, we find that the link between CFO option sensitivity and crash risk is more pronounced for firms in non-competitive industries and those with a high level of financial leverage. 
Interesting Excerpt:
Based on the findings of our study and that of Fahlenbrach and Stulz (2010), we argue that it is unlikely that option-induced managerial risk taking per se increases crash risk. However, given the extensive risk-taking behavior of the financial industry before the financial crisis, it is still early to completely rule out the role of excessive risk taking in creating crashes. To continue our bad news hoarding story, we conjecture that, rather than risk taking itself, the hiding of excessive risk-taking behavior from investors contributes to crash risk. If rational investors and the board of directors are aware of an undesired high level of managerial risk-taking behavior, they will take timely corrective actions to stop or constrain such risk-taking behavior. However, given that managers’ wealth is tied to stock price by equity incentives, managers will withhold information about excessive risk taking to maintain share price. As a result, managers take too much risk and the uninformed investors/boards are unable to take timely corrective actions or adjust price levels accordingly until a crash occurs. This line of argument seems to be consistent with the recent SEC investigation of the Lehman bankruptcy case. According to the Wall Street Journal (Kelly et al., 2010), an SEC examiner found that Lehman engaged in an accounting device known within the firm as ‘Repo 105’ to achieve extensive short-term off-balance-sheet financing, which helped Lehman look like it had less debt on its books.


  1. Nadine,

    There is something wrong with the link, can't download the paper. Sounds interesting though.

    The CEB report states that employees do not give bad news or negative feedback to bosses if they fear job loss. In such a case in most cases CFO reports to CEOs. Will the same apply to them also, CFOs are scared of CEOs also, especially if there is an aggressive or devaint behavior. I think it is a multitude of factors, though cant say that half the things which CEOs do can be done without the help of a CFO. Will analyse more after reading the paper.


  2. Hi Sonia,

    I apologize about the link.. it should be working now.

    In theory, the idea of matching executive compensation with market price seems like it would work to everyone's benefit. It would look like the executives are working for the benefit of themselves as well as their shareholders. But it is apparent that this theory has backfired as most executives want constant increases in their stock price when the reality is not so.

    In any event, take a look at the paper... I think you will find it interesting.