Causes Of The Credit Crisis

Submitted By CalifornianDream
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I am not interested in the causes of the credit crisis; the credit crisis sets the scene and provides an example so a little bit of information on the crisis in the introduction is fine.
What the real question is from a Management Accounting perspective is “Do incentives cause people to behave in a certain way and if yes where is the evidence for this”.

There are many versions of the poor incentives explanation of the crisis. One version is that CEOs had strong incentives to focus on the short run instead of the long run. Another version is that option compensation gave incentives to CEOs to take more risks than would have been optimal for shareholders. A third version is that the high leverage of financial institutions implies that CEOs can increase the value of their shares by increasing the volatility of the assets because the shares are effectively options on the value of the assets. Though the incentives of CEOs can be such that they focus too much on the short run, that they take too much risk, and that they choose excessive leverage, it is by no means obvious that CEO incentives in banks had these implications. In particular, large holdings of equity by CEOs could in fact lead them to focus appropriately on the long run, to avoid some risks that might be profitable for shareholders, and to avoid excessive leverage.
Whether greater sensitivity of CEO wealth to volatility makes the CEO’s interests better aligned with the interests of shareholders would seem to depend on many considerations. For example, if the CEO’s holdings of stock make him more conservative, greater sensitivity of his wealth to volatility would help in aligning the CEO’s incentives with those of shareholders. For given asset volatility and expected cash flows from
A bank’s stock return performance in 2007–2008 is negatively related to the dollar incentives derived from its CEO’s holdings of shares and options in 2006. This effect is substantial. An increase of one standard deviation in dollar incentives is associated with lower returns of 9.6 percentage points. Similarly, a bank’s return on equity in 2008 is negatively related to its CEO’s dollar incentives in 2006.
CEOs could have sharply decreased their holdings after 2006 but before the full impact of the crisis, so that they did not have to bear the cost of the exposures they took. In that case, they would have appeared to have incentives aligned with those of the other shareholders in 2006, but they would have traded out of these incentives or would have hedged them. Consequently, their behaviour in 2006 might have been based on their knowledge that they would trade out of these incentives before the value of their portfolio fell substantially. For such a strategy to make sense, CEOs would have had to be able to anticipate the crisis. We investigate the insider trading of bank CEOs in 2007–2008. We find no evidence that they traded out of
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