part 3

[Audio] We would like to discuss the issue of institutional investor incentives to monitor specifically with regards to pension fund managers. While bankers can efficiently delegate monitoring by offering a fixed return on deposits pension fund managers do not have the same disciplining threat to monitor effectively. The analysis of institutional investor incentives to monitor has mainly focused on bank monitoring. In 1984 Diamond showed that bank monitoring by a banker may be efficient and that the bank's diversification can almost perfectly guarantee a fixed return to its depositors. However the preservation of the banker's incentives to monitor also requires careful specification of deposit contracts such as no deposit insurance and the first-come first-served feature of bank deposit contracts. Pension fund managers on the other hand do not have the same disciplining threat to monitor effectively. Despite mandatory requirements for activism pension fund managers do not appear to have strong incentives to monitor managers. It's worth noting that U S institutional activism can be ineffective or misplaced and more generally banks are not just delegated monitors but also delegated renegotiators. Therefore it's important to consider the specific context and contracts when analyzing institutional investor incentives to monitor..

[Audio] Institutional Investor Incentives to Monitor in the financial sector. Under a regime of deposit insurance banks will not adequately monitor firms and will engage in reckless lending. This has been corroborated by the greater incidence of banking crises in the past 20 years. While the origin of these crises is a debated issue many commentators argue that the recent banking crises are just as (or more) likely to have resulted from exchange rate crises and/or a speculative bubble. Depositors' abilities and incentives to monitor banks are often put into question. It is important to note that the moral hazard problem is exacerbated by banks' incentives to hide loan losses as Mitchell (1998) and Aghion Bolton and Fries (1998) have pointed out. Additionally banks' inability to commit ex ante to terminate inefficient projects may also exacerbate moral hazard. However banks also have a bias towards liquidation of distressed lenders as senior (secured) debt-holders. In conclusion the effectiveness of bank monitoring depends on bank managers' incentives to monitor. These incentives in turn are driven by bank regulation. It is crucial for financial institutions to have adequate monitoring mechanisms in place to prevent and mitigate the negative effects of financial crises..

[Audio] We will analyze the effectiveness of bank monitoring and the different models that can be used to address the collective action problem among dispersed shareholders. We will first discuss the regulatory model. While this model can be effective when the banking system is healthy it can fail during a system-wide crisis as seen in the case of Gorton and Winton in 2001. The effectiveness of bank monitoring can vary with the aggregate state of the banking industry which can explain the perception that Japanese banks played a positive role in the 1970 seconds and 1980s while in the 1990 seconds they were more concerned with covering up loan losses than effectively monitoring the corporations they lent to. Next we will discuss the board model. This model involves monitoring the C-E-O by a board of directors. Most corporate charters require that shareholders elect a board of directors whose mission is to select the C-E-O monitor management and vote on important decisions such as mergers & acquisitions changes in remuneration of the C-E-O changes in the firm’s capital structure like stock repurchases or new debt issues et cetera However boards are often 'captured' by management due to C-E-Os having considerable influence over the choice of directors and superior information. Even when boards have achieved independence from management they may not be as effective as they could be because directors prefer to play a less confrontational 'advisory' role than a more critical monitoring role. Finally directors generally only have a very limited financial stake in the corporation. In conclusion the effectiveness of bank monitoring can vary with the aggregate state of the banking industry and different models can be used to address the collective action problem among dispersed shareholders..

[Audio] We will present the limitations of requiring independence of the board to monitor effectively. Independent directors can reduce C-E-O influence over the board but they may lack knowledge or information to effectively monitor. Moreover dependent on C-E-O for reappointment independent directors may struggle to protect minority shareholders' interests against C-E-O and blockholder actions. In corporations with concentrated ownership independent directors must protect minority shareholders' interests against both C-E-O and blockholder actions. However research suggests a mixed impact of independent directors on firm performance and there may be no significant relation between firm performance and board composition. Commentators view these regulations with scepticism and most research on boards and impact of independent directors is empirical. Therefore other approaches to incentivize effective monitoring should be considered such as offering fixed return on deposits as discussed in slide 3..

[Audio] We will discuss the role of boards of directors in monitoring management..

[Audio] Incentivize monitoring in banking and pension fund management. Banks delegate monitoring efficiently by offering a fixed return on deposits preserving their incentives to monitor. In contrast pension fund managers lack this disciplining threat. Shareholders suggest that boards are active only in crisis situations and limiting dismissal and introducing fixed term limits can improve their vigilance. Rajeha models the selection process of directors and shows how it may vary with underlying firm characteristics. Hirshleifer and Thakor analyze the interaction between inside monitoring by boards and external monitoring by corporate raiders. Adams focuses on the conflict between monitoring and advisory functions suggesting a dual board system. Noe and Rebello and Maug provide further analysis of the functioning of boards takeovers and leverage in disciplining management..

[Audio] We found that bankers can efficiently delegate monitoring by offering a fixed return on deposits. However pension fund managers may not have the same disciplining threat to monitor effectively. Another way to improve shareholder protection is through executive compensation. Most compensation packages in publicly traded firms include a basic salary component a bonus related to short-term performance and a stock participation plan such as stock options. These packages also include various other benefits such as pension rights and severance pay. In the U S a compensation committee of the board is responsible for setting executive pay relying on market standards for determining the level and structure of compensation. However there is much to explore in the field of executive compensation and its relationship to board governance and effective monitoring of management..

[Audio] We analyze the incentives for institutional investors to monitor. Bankers can delegate monitoring by offering a fixed return on deposits. However pension fund managers do not have the same disciplining threat to monitor effectively. We examine the determination of executive pay through the general theory of contracting under moral hazard. However there is concern that stock options may be used by C-E-Os to enrich themselves at the expense of shareholders. There has been no attempt to analyze the determination of executive pay along the lines of Hermalin and Weisbach (1998) by explicitly modeling the bargaining process between the C-E-O remuneration committee and board members. Instead most existing formal analyses have relied on the general theory of contracting under moral hazard to draw general conclusions about the structure of executive pay. This includes the trade-off between risk-sharing and incentives and the desirability of basing compensation on all performance measures that are informative about the CEO's actions. Compensation committees often rely on the advice of outside experts who make recommendations based on observed average pay the going rate for the latest hires and/or their estimate of the pay expected..

[Audio] Executive compensation consultants design compensation contracts without considering the relative informativeness of different performance measures. They are instead driven by implicit and explicit incentives. Explicit incentives should increase with age and tenure as C-E-Os with longer tenure have lower implicit incentives. This is an issue with the agency theory that justifies executive compensation schemes. Options can be highly motivational but it is important to be careful about what we are asking them to motivate..

[Audio] We will analyze institutional investor incentives to monitor discuss how bankers can efficiently delegate monitoring by offering a fixed return on deposits highlight that pension fund managers do not have the same disciplining threat to monitor effectively discuss the important link between executive compensation and corporate governance and explore the process of determination of executive pay. We will also discuss the importance of board representation in corporate governance and the challenges in determining the extent to which boards should be mandated to have representatives of other constituencies besides shareholders. Additionally we will explore the complexity of board representation and the need for more formal exploration of these issues..

[Audio] We can examine different models proposed for dividing control between managers shareholders and creditors. One such model is that suggested by Aghion and Bolton (1992) which captures basic elements of a multi-constituency situation and provides rationale for extending control to other constituencies than shareholders. Another rationale for dividing control with creditors is given in studies by Zender (1991) Diamond (1991 1993) Dewatripont and Tirole (1994) Berglof (1994) Hellman (1997) Neher (1999) and Kaplan and Stromberg (1999). These studies have analyzed control allocation in various contexts and highlighted prevalence of contingent control allocations in venture capital contracts. In summary models proposed for dividing control between managers shareholders and creditors have provided rationale for extending control to other constituencies than shareholders and highlighted prevalence of contingent control allocations in various contexts..

[Audio] Our analysis finds that fixed return on deposits and liquidation incentives are effective for bankers and pension fund managers in incentivizing institutional investors in higher education to monitor. However termination threat may be an effective incentive scheme. Additionally we explore the role of shareholders creditors and a diffuse ownership structure in limiting management power and ensuring accountability in higher education institutions..

[Audio] Institutional investors play a crucial role in monitoring corporate behavior. The incentives for bankers and pension fund managers to monitor effectively are analyzed in depth. Efficient monitoring can be achieved by bankers by offering a fixed return on deposits which preserves their incentives to monitor. However pension fund managers may not have the same disciplining threat to monitor effectively as they do not have the same level of specific investment. The theory of property rights is helpful in understanding this concept. This theory deals with the protection of both physical and human capital investments. The 'holdup' problem which refers to the potential ex-post expropriation of unprotected returns from ex ante (specific) human capital investment is a key issue in this theory. This is particularly relevant for research and development investments where the inventor may not have the ability to specify the terms of trade before the invention is created. In summary institutional investors play an important role in monitoring corporate behavior. Understanding the concepts of property rights and the holdup problem can help institutional investors better monitor and protect their investments..

[Audio] Banks can efficiently delegate monitoring by offering a fixed return on deposits which preserves their incentives to monitor. However pension fund managers do not have the same disciplining threat to monitor effectively. This can be understood through the theory of property rights which suggests that shared control with employees can be efficient whenever they make valuable firm-specific human-capital investments. For example in the case of an inventor sharing control with employees can help protect them against ex-post expropriation or hold-up by management or the providers of financial capital. This is because employees are more likely to invest in firm-specific human capital when they have adequate protection against such threats. This theory also provides a useful analytical framework for assessing the costs and benefits of privatisation of state-owned firms. For instance Hart Shleifer and Vishny (1997) argue that privatised firms have a better incentive to minimise costs but this may also lead to the provision of poorer quality service. Schmidt (1996) and Shapiro and Willig (1990) emphasise a different trade-off arguing that under state ownership the government has better information about the firm's management but the government also tends to interfere too much. Overall the theory of property rights highlights the importance of effective monitoring in protecting employees against ex-post expropriation or hold-up and in ensuring that they invest in firm-specific human capital. This is especially important for banks which rely heavily on human capital to monitor and manage their portfolios..

[Audio] Institutional investors can efficiently delegate monitoring by offering a fixed return on deposits while preserving their incentives to monitor. However pension fund managers do not have the same disciplining threat to monitor effectively. Institutional investors should carefully consider the impact of employee representation on their investments and develop strategies to mitigate any negative effects in order to maximize their returns and ensure the long-term success of their investments..

[Audio] We analyze the models used to determine the most effective governance structure for institutional investors. One extreme result highlighted by Roberts and Van den Steen (1999) is that it may even be efficient to have employee-dominated boards when only human capital investment matters. Examples of such governance structures are not uncommon in practice especially in the professional services industry. Most accounting consulting or law partnerships effectively have employee-dominated boards. Another example is universities where academics not only have full job security (when they have tenure) but also substantial control rights. Hansmann (1996) and Hart and Moore (1996 and 1998) are concerned with another aspect of governance by employees. They ask when it is best to have ‘inside’ ownership and control in the form of an employee cooperative or partnership or when ‘outside’ ownership in the form of a limited liability company is better. A central prediction of the property rights theory is that ownership and control rights should be given to the parties that make ex-ante specific investments. However as Hansmann and Hart and Moore observe the dominant form of governance structure is ‘outside’ ownership..

[Audio] Discussing the impact of institutional investors on governance and monitoring within firms. While bankers can effectively delegate monitoring by offering fixed return on deposits which preserves their incentives to monitor pension fund managers may struggle to effectively monitor their investments. One reason for this is the distortion that outside ownership can introduce. Models often assume away all governance issues related to dispersed ownership and only consider the impact of a single large shareholder. However studies have shown that a large shareholder may introduce distortions in their attempt to extract a larger share of the firm's value even at the expense of greater value creation. The property rights theory of Grossman Hart and Moore provides one rationalization for sharing corporate control with employees and for employee representation on the board: protection of employees' firm-specific investments. However there may be other reasons for employee representation such as better monitoring of management by employees who are likely to be better informed and in a better position to monitor company pension plans. While these reasons may be persuasive it does not necessarily follow that rules mandating employee representation on the board are necessarily desirable. As we mentioned earlier such rules can only be justified by appealing to a contractual failure of some kind..

[Audio] Institutional investor incentives are crucial for ensuring the efficiency and effectiveness of corporate governance. However the ability of these investors to monitor is dependent on the specific circumstances of the firm. Banks may offer fixed returns on deposits to incentivize monitoring while pension fund managers may not have the same disciplining threat to monitor effectively. To illustrate this point we examine the models proposed by 1987 and Scharfstein 1988. We also consider the potential failure of a firm's founders to allow for employee representation which may send a bad signal to potential investors. However even if contractual failures exist they must be weighed against other potential inefficiencies that may arise as a result of multi-constituency representation on the board such as shareholder responses to weaken employee influence greater board passivity or less disclosure of valuable but divisive information by management. One argument against multiple constituencies is that when the firm's management is required to trade off the interests of different constituencies one important 'side effect' is that management gains too much discretion. This argument is particularly relevant when defining the CEO's fiduciary duties (or 'mission'). The current narrow definition of fiduciary duties in the U-S is already balanced by the 'business judgement rule' which makes it difficult for plaintiffs to prevail. Adding a 'protection of other constituencies rule' would make winning a suit even harder. However note that this argument is less so when applied to board representation. Having representatives of creditors employees or related firms on the board does not per se increase the manager's discretion. The manager is still monitored by the board and will still have to deal with the majority of directors that control the board..

[Audio] Our analysis has shown the importance of effective monitoring for pension fund managers. We recognize the challenges faced by these managers in monitoring effectively. To address these challenges we have emphasized the need for a systematic analysis of corporate governance including the role of politics in shaping regulation. We have discussed the difficulties of deciding who should participate in governance regulating takeovers and defining appropriate legal actions against managerial abuses. Institutions looking to improve their monitoring practices must take into account the complexities of corporate governance and the multiple constituencies of corporations. There are no unique solutions and our analysis has shed light on these complexities and provided useful insights for institutions..