Print
E-MailAdam Kolasinski is a Professor of Finance at Texas A&M University, and Nan Yang is an Associate Professor of Finance at the Hong Kong Polytechnic University. This post is based on their working article. Related research from the Program on Corporate Governance includes Lucky CEOs and Lucky Directors (discussed on the Forum here) by Lucian A. Bebchuk, Yaniv Grinstein, and Urs Peyer.
Strict securities accounting rules that require the recognition of unrealized securities losses in earnings caused banks sell mortgage-backed securities into negative liquidity shocks, a disruptive activity sometimes called, “liquidity feedback trading.” The underlying economic mechanism behind liquidity feedback trading, however, is still poorly understood. Prior scholarly research exclusively investigated a proposed mechanism related to capital ratio compliance concerns, but evidence that this mechanism played major role has proven elusive. Despite the lack of understanding of the economic mechanism behind liquidity feedback trading, in effort to prevent it, regulators in 2009 relaxed accounting rules requiring recognition of unrealized losses. For all but the largest banks in the U.S., these relaxed rules persist, so securities unrealized losses, particularly those related to interest rate movements, are often not charged to earnings or bank capital. Moreover, such unrealized and unrecognized losses featured prominently in the failures of First Republic, Silicon Valley, and Signature Banks during the spring of 2023 (e.g., Flannery and Sorescu, 2023).
In a new study forthcoming in Management Science, we present evidence that bank chief executive officers’ (CEOs) incentives for short-term focus help liquidity feedback trading. Our empirical analysis is motivated by Plantin et al. (2008), which introduce the mechanism based on short-term incentives (the “myopia mechanism”) with their theoretical model of liquidity feedback trading. In the model, an asset’s price is not just a function of fundamentals, but also decreasing in the number of banks that have already sold it during a period. Under the strict fair value accounting regime, banks must charge to earnings all unrealized losses. If a bank sells while others are selling, the sooner the trade is executed, the better the price it gets. Banks that refrain from selling must charge to earnings an unrealized loss equal to the last-selling bank’s realized loss, which, by construction, is larger than the loss of all other selling banks. Now CEOs with short-term (or “myopic” CEOs) will tend to maximize short term earnings. Therefore, myopic CEOs always sell when liquidity shocks temporarily drive prices below fundamental value, even though such selling destroys bank shareholder value. In contrast, CEO maximizing their own banks’ long-term fundamental value will refrain from selling undervalued assets. The model thus implies that banks led by CEOs with short-term incentives will tend to destroy shareholder value by selling into negative liquidity shocks under strict accounting rules requiring recognition of unrealized losses in earnings, but not under looser accounting rules. CEOs with long-term incentives will tend not to engage in this behavior regardless of accounting rules.
To construct our measure of incentives for short-term focus, we use CEO equity duration, defined by Gopalan et al. (2014), as the weighted average time CEOs must wait to cash out of their stock and option holdings. CEOs who can cash out earlier will have stronger incentives to engage in value-destroying activities that happen to increase earnings in the short run. A short equity duration, in turn, allows CEOs to cash out more of their holdings before the negative consequences are revealed.
Our core analysis is to examine bank shareholders’ reaction to news indicating increased likelihood of relaxing the fair value securities impairment rules. If accounting rules are loosened so myopic CEOs can avoid taking recognizing unrealized losses, the Platin et al. model of feedback trading predicts they will stop destroying shareholder value through feedback trading. Thus, the model implies stock prices of banks led by myopic CEOs will rise upon news of the accounting rule relaxation. In contrast, we do not expect to observe a similar rise in banks led by less myopic CEOs, as they tend not to engage in liquidity feedback trading regardless of the accounting regime. Our empirical findings confirm the prediction: stock prices of banks react less favorably to accounting relaxation news if their CEOs have a longer equity duration, as long as their banks are holding securities prone to liquidity socks.
We also directly test whether banks led by myopic CEOs are more prone to liquidity feedback trading before accounting rules were loosened. As expected, we find that banks whose CEOs have shorter equity durations engage in more disruptive trading during the stricter regime. In additional analyses, we carefully rule out alternative stories that could explain findings. Notably, our prior paper published in Journal of Financial Economics (Kolasinski and Yang, 2018) finds that banks with short CEO equity durations had greater subprime security holdings than banks with long CEO equity durations. We confirm that differential security holdings cannot explain the findings in this study.
Our research implies that stronger incentives for bank CEOs to focus on the long term mitigate some of the undesirable side effects of stricter securities accounting rules. Hence, we suggest that regulators contemplating the effects of accounting rules on securities markets should also consider how they interact with incentives created by executive compensation packages at banks.
We believe our paper is particularly timely given the recent failures of Silicon Valley, Signature, and First Republic banks, which have re-ignited the debate on the fair accounting rules in the banking industry. Strict, fair value–based securities accounting rules require bank to report their assets based on the economic value, which enhances banks’ self-monitoring and allows timely intervention by regulators. Stephen Ryan, an accounting professor at New York University, is quoted in Financial Times article as saying, “Had Silicon Valley Bank or any of the other affected banks been using fair value for their long-term market securities, they would have had to cope with the rises in interest rates as they occurred rather than putting it off until a stress point.” Unfortunately, because regulators wanted to avoid the consequences of disruptive feedback trading during the subprime crisis, they kept lax securities accounting rules in place that allowed banks to ignore the major losses until they ultimately collapsed. Our results suggest that stricter rules would have posed fewer problems related to disruptive trading had banks put better incentives in place for their CEOs.
There are also several studies that examine the effects of executive incentives for short-term focus, but none examines the association of such incentives with accounting rules. Our results suggest that boards of directors should carefully consider the degree to which the pay packages they give corporate executives create incentives for short-term focus, rather than for the creation of shareholder value that is sustainable in the long term.
