More Manipulation, Less Risk Taking?
26 Pages Posted: 6 Jun 2014
Date Written: June 5, 2014
Executive stock options are a dominant component of managers pay in the United States. This common compensation feature entails two perverse side effects: driving managers to engage in manipulative practices, and generating excessive risk-taking. Tellingly, some scholars blame the first side effect for the wave of Enron-style fraud in 2001-2002 and the second for the 2007-2010 financial crisis. To date, however, no one has investigated the interaction between these two types of adverse incentives, for manipulation and risk-taking. In this paper, we study the effects of manipulation practices on risk-taking decisions of managers holding large amounts of stock options. We first show that sufficient manipulation restrains excessive risk-taking but it does not impede managers from taking beneficially risky projects. We then show that mild levels of manipulation have complex effects on managers’ preference for risk taking, but they too tend to decrease risk taking. Our analysis suggests that when regulation improves disclosure and impedes manipulative practices, excessive risk taking may erupt. Policy-wise, we recommend that anti-manipulative regulatory policies be accompanied by measures designed to prevent excessive risk taking.
Keywords: Financial Crisis, Stock Options, Manipulation, Risk-Taking
JEL Classification: G3, K2
Suggested Citation: Suggested Citation