Bruce I. Carlin, UC, Los Angeles and NBER; and Simon Gervais, Duke University
Legal Protection in Retail Financial Markets
Given the importance of sound advice in retail financial markets and the fact that financial institutions often outsource their advice services, what legal rules maximize social welfare in the market? Carlin and Gervais address this question by posing a theoretical model of retail markets in which a firm and a broker face a bilateral hidden action problem when they service clients in the market. All participants in the market are rational, and prices are set based on consistent beliefs about equilibrium actions of the firm and the broker. The researchers characterize the optimal law in the context of their model, and derive how the legal system splits the blame between parties to the transaction. They also analyze how complexity in assessing clients and conflicts of interest affect the law. Since these markets are large, the implications of the analysis have great welfare import.
Viral V. Acharya, New York University and NBER; Stewart C. Myers, MIT and NBER; and Raghuram Rajan, University of Chicago and NBER
The Internal Governance of Firms
Acharya, Myers, and Rajan develop a model of internal governance where the self-serving actions of top management are limited by the potential reaction of subordinates. Internal governance can mitigate agency problems and ensure that firms have substantial value, even with little or no external governance by investors. Internal governance works best when both top management and subordinates are important in generating cash flow. External governance, even if crude and uninformed, can complement internal governance and improve efficiency. This leads to a theory of investment and dividend policy, where dividends are paid by self-interested CEOs to maintain a balance between internal and external control. This paper can explain why firms with limited external oversight, and firms in countries with poor external governance, can have substantial value.
Vikas Agarwal, Georgia State University; Wei Jiang, Columbia University; Yuehua Tang, Georgia State University; and Baozhong Yang, Georgia State University
Do Institutional Investors Have an Ace up Their Sleeves? Evidence from Confidential Filings of Portfolio Holdings
Agarwal, Jiang, Tang, and Yang study the holdings of institutional investors that are filed with a significant delay through amendments to Form 13F and not included in the standard 13F holdings databases -- in other words, the confidential holdings. The researchers find that asset management firms (hedge funds and investment companies/advisors) in general, and institutions that actively manage large and risky portfolios in particular, are more likely to seek confidentiality. The confidential holdings are disproportionately associated with information-sensitive events such as mergers and acquisitions, and include stocks subjected to greater information asymmetry. Moreover, the confidential holdings of asset management firms exhibit superior risk-adjusted performance up to four months after the quarter end, suggesting that these institutions may possess short-lived information. This study highlights the tension between the regulators, public, and investment managers regarding the ownership disclosure, provides new evidence in the cross-sectional differences in the performance of institutional investors, and highlights the limitations of the standard 13F holdings databases.
Ronen Avraham, University of Texas School of Law; Leemore Dafny, Northwestern University and NBER; and Max Schanzenbach, Northwestern University Law School
The Impact of Tort Reform on Employer-Sponsored Health Insurance Premiums
Avraham, Dafny, and Schanzenbach evaluate the effect of tort reform on employer-sponsored health insurance premiums by exploiting state-level variation in the timing of reforms. Using a dataset of healthplans representing over 10 million Americans annually between 1998 and 2006, they find that caps on non-economic damages, collateral source reform, and joint and several liability reform reduce premiums by 1 to 2 percent each. These reductions are concentrated in PPOs rather than HMOs, suggesting that can HMOs can reduce "defensive" healthcare costs even absent tort reform. The results are the first direct evidence that tort reform reduces healthcare costs in aggregate; prior research has focused on particular medical conditions.
Stefania Albanesi, Columbia University and NBER; and Claudia Olivetti, Boston University and NBER
Gender and Dynamic Agency: Theory and Evidence on the Compensation of Top Executives
Albanesi and Olivetti document three new facts about gender differences in executive compensation. First, female executives receive lower share of incentive pay in total compensation relative to males. This difference accounts for 72 percent of the gender gap in total pay. Second, the compensation of female executives displays a lower pay-performance sensitivity. A $1 million dollar increase in firm value generates a $70 increase in total compensation for male executives and a $28 increase for females. Third, female executives' total pay is more sensitive to bad firm performance and less sensitive to good firm performance and aggregate stock market performance relative to males. The researchers also show that there is no link between firm performance and the gender of top executives. They discuss evidence on differences in preferences and the cost of managerial effort by gender and examine the resulting predictions for the structure of compensation. They consider two paradigms for the pay-setting process, the efficient contracting model under moral hazard and the "managerial power" or skimming view of executive compensation. The efficient contracting model can explain the first two facts. Only the skimming view is consistent with the third fact. This suggests that the gender differentials in executive compensation may be inefficient.
Christopher Snyder, Dartmouth College, and Wallace P. Mullin, George Washington University
Deterring Nuisance Suits through Employee Indemnification
Broad employee indemnification is pervasive among corporations. Indemnification covers individual sanctions, such as fines, for corporate actions. These guarantees that are not merely tolerated but indeed encouraged by public policy. Snyder and Mullin offer a new rationale for widespread indemnification. Indemnification deters meritless civil suits (as well as prosecution by non-benevolent officials) by strengthening employees’ resolve to fight them.
Edoardo Di Porto, EQUIPPE, USTL Lille; Nicola Persico, New York University and NBER; and Nicolas Sahuguet, HEC Montréal and CEPR
Tax Auditing Without Commitment, With an Application to Labor Tax Evasion in Italy
Di Porto, Persico, and Sahuguet provide an identification result for a general class of auditing games, which allows them to falsify the joint hypotheses that: 1) the auditor has no commitment powers, and 2) the auditor has a specific objective function. They apply this identification result to a unique tax auditing dataset on the universe of labor-tax audits in Italy. These audits are carried out by the Italian social security agency INPS. The researchers find that they cannot reject the joint hypotheses that: 1) INPS has a no-commitment strategy; and 2) INPS maximizes the success rate of audits, that is, the probability that the audited firm is found under-reporting by any amount. They then develop a new strategic auditing model in which INPS auditors cannot commit to an auditing strategy, and they maximize the success rate of audits. They solve for Nash equilibrium strategies for firms and auditors in closed form. Under standard assumptions about the distribution of firm sizes, the equilibrium can reproduce an additional finding from the INPS data: namely, that the monetary value of tax evaded is increasing in the true tax base of the firm. Next, the authors impose a parametric restriction on the distribution of (unobserved) tax bases of firms, and compute the Nash equilibrium of their model in this parametric case. They calibrate the parameters of the Nash equilibrium outcomes to certain moments coming from the INPS dataset. In this way, they are able to recover the unobserved parameters governing the distribution of true tax bases of firms, using the information coming from the (non-randomly) audited firms. Finally, they use the parameters recovered via this methodology to perform the following counterfactual investigation: how much more revenue could INPS raise if it committed to a (carefully chosen) auditing strategy?