Dynamic Agency and Large‐Risk Taking

• Published date: 01 June 2019
• Date: 01 June 2019
• DOI: http://doi.org/10.1111/irfi.12172
• Author: Rui Li

Dynamic Agency and Large-Risk

Taking

RUI LI

Department of Accounting and Finance, University of Massachusetts Boston,

Boston, MA

ABSTRACT

I propose a dynamic investment model with moral hazard under which

greater exposure to future uncertainties about losses could enhance incentive

provisions and improve firm value. The model provides an explanation for

why many financial companies and investment banks choose to improve

their short-run performance by putting themselves at greater risk of cata-

strophic losses in the future, as what happened prior to the 2007 financial

crisis.

JEL Code: G32

Accepted: 1 December 2017

I. INTRODUCTION

People attribute the 2007 financial crisis to reckless risk-taking behavior in the

financial industry. For example, many financial companies and investment

banks raised their short-run income by selling billions of dollars’worth of insur-

ance against unlikely events. When the economy was healthy, they pocketed

the fees from the sales, but in doing so, they exposed themselves to a greater

possibility of catastrophic losses in the future, triggered by a downturn in the

economy. A vast literature has been devoted to understanding the motivations

behind this risk-taking behavior. Most of the existing papers rationalize it with

the hidden risk-taking actions of the managers and traders that are motivated

by conflict incentives. For example, Jensen and Meckling (1976) show that a

convex incentive scheme such as levered equity and options could lead to

aggressive risk-taking. Recently, DeMarzo et al. (2014) and Li and Williams

(2016) show that pay-performance sensitivity under the optimal contract

induces managers to improve short-run performance by secretly taking exces-

sive risks.

Although in reality some of the risk-taking actions of the firm managers are

hidden, the majority of them are observable to the boards. For example, many

financial companies increasingly sell credit default swap contracts, the quanti-

ties of which are shown in their financial reports and were approved by the

administration councils within their boards. So, the rationale behind the

© 2017 International Review of Finance Ltd. 2017

International Review of Finance, 19:2, 2019: pp. 471–480

DOI: 10.1111/irfi.12172