Corporate Governance and Risk Aversion

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Corporate Governance and Risk Aversion.

Corporate governance defines the infrastructure of an institution. It is a system or practices, rules and procedures by which a company is controlled and directed. The role of corporate governance is to balance and align the interests of all stakeholders in a firm. These are the shareholders, the management, the customers, the government, the suppliers and the community impacted by the business unit. Corporate governance provides the framework for realizing the goals and objectives of a company. The main goal of any company is to give maximum returns for investment. Corporate governance lays down the internal controls, corporate disclosure mechanisms, action plans and performance evaluation mechanisms for the achievement of the firms’ objectives. Through efficient corporate governance the company demonstrates its ethical elements, environmental awareness and impressive corporate citizenship.

Risk aversion is an economics and finance concept that describes the attitude towards risk of different players in a business setting. It explains the behavior of investors in an attempt to reduce uncertainty when exposed to uncertainty. Risk aversion is the reluctance of an investor to accept a given bargain with uncertain returns as opposed to another bargain with certain returns but possibly lower. For instance an investor XYZ, with $50,000 may decide to put all this sum in a bank account where he will earn low but guaranteed interest as opposed to investing the $50,000 in stocks, where he is likely to have high expected returns but also high risks e.g. chances of losing all the $50,000. A risk averse investor dislikes risk. Therefore, he will stay away from high risk investments but this has the disadvantage of losing out on higher rates of returns. Such investors usually stick to safer investments like government bonds and index funds which have considerably low returns.

There are three basic attitudes towards risk by investors. Some investors are risk averse or risk avoiding. Such investors will only accept a bargain where they are certain to make returns. Some other investors are risk loving. Such investors will accept a bargain even when there is no guarantee that they will make any returns. Such investors stand to make high returns for their investment though there is a high risk of losing all the investment. Other investors are risk neutral. Such investors are indifferent whether there is certainty to reap returns or not. In such scenarios the expected returns from an investment is known as the expected return, the expected returns with a high margin of certainty is known as certainty equivalent and the difference between the two is known as the risk premium.

In any business corporation for successful operations the interests of the managers must be perfectly aligned to those of the shareholders. This must be clearly brought out in corporate governance. In this case the manager who is the employee of the shareholders is known as the agent and the shareholder who is the employee is known as the principal. The shareholders invest their money in a firm. Unlike the shareholders the managers do not usually have any of their money invested in the business. The managers must always invest in a way that the shareholders get the maximum returns for their investment. They must also completely eliminate any losses. In order to achieve these objectives there is the need by the managers to minimize risks and make prudent corporate investment decisions. In order to meet with the shareholders expectations most managers tend to be aligned to risk aversion. By so doing they advance their own interests at the expense of the interests of the shareholders. This is a safe alternative that guarantees returns with a minimal margin of uncertainty. However this is not the best model because the rate of returns is usually lower. This kind of a scenario is called a principal agent problem in economics.

In order to deal with the principal agent problem, one of the best responses is the shareholders increasing the monitoring on the management. This can be achieved through thorough scrutiny of the managers’ work by the shareholders. However, this is not practical because it is very expensive in terms of the shareholders time and resources. This necessitates the need for a more direct way to deal with the problem. The solution of this issue needs to be facilitated by corporate governance.

The element of corporate governance that helps to align the interests of the shareholders with the interests of the managers is contained in the contract design. It is the most appropriate way of dealing with the principal agent problem and avoiding risk aversion. This is usually done in the initial stages of engagement of the managers and the shareholders. Both economic actors, i.e. the shareholders and the managers, can construct the contractual arrangements in a way that discourages risk aversion. This is achieved by using the information available and finding theoretical procedures to model or design the contract in a way that it motivates the managers to make appropriate decisions. The contract design that is successful is the one that comes up with plans to align the interests of the shareholders with the interests of the managers.

One popular policy among firms that is incorporated in the contract design is granting stock options to employees. This is mainly for the employees in the upper management. The stock options are part of the employees compensation based on performance. The value of the stocks usually rises as the value of the company’s stock rises. As a result the financial well-being of the firm is directly tied to the recipient of such a stock option. As a result the managers are motivated to put in more effort in the growth if the company since this directly translates to more returns for them. It has also been shown that the stock option instills a sense of responsibility in the employees since they now own a part of the firm hence they become obliged to ensure upward growth of the firm. They are also motivated to make prudent corporate decisions involving high returns but high risks because they know they stand to gain a lot if the high risk high returns investment succeeds. Therefore, this helps to avoid risk aversion.

Another policy that is incorporated into the contract design to successively curb risk aversion is where the shareholders pay the manager a wage that is way above the market wage. This is usually referred to as an efficiency wage. This policy is known as the Shapiro-Stiglitz model. It was developed by Carl Shapiro and Joseph E. Stiglitz in 1984. This model is aimed at preventing the workers from being lazy or slacking off. The opportunity cost of getting fired is the lost wages which the employee is unlikely to get anywhere else. This induces the employee not to slack. Also, if one firm pays efficiency wages, then all firms in the same industry are likely to be compelled to pay the efficiency wages too in order to compete for workers. As a result all the wages in this case are above the market wage level leading to involuntary unemployment of workers in this industry. This has the effect of diminishing the chances that a fired worker will find another job after being fired. Therefore, the employee is compelled not to slack. This also discourages risk aversion because the employee is bound to perform exemplary and risk aversion can’t achieve that.

Another policy that is incorporated in contract design to successfully mitigate risk aversion is performance-based remuneration. In this model the performance of the employees is benchmarked and the employees are compensated according to the value of the work done. A common way of doing this is trough commissions. The output value of the worker is determined. The worker then gets a percentage of the total returns as compensation. This way the worker is motivated avoid tax aversion in order to be more productive. The productivity of the worker will be directly reflected in the workers compensation.

Another form of performance based contract design is provision of employment on condition for performance. Under such contractual arrangement the worker is not employed indefinitely. The employment is time based with possible renewal of employment after a given time or sacking. For instance, a manager may be employed by the shareholders for one financial year with the condition of achieving a 10% growth on the company’s revenue within that period. If the manager has achieved the growth stated in the contract by the end of the year, the employment contract will be renewed. However if the manager does not achieve the growth as stipulated in the contract he will be fired at the end of that financial year. Therefore, in order to retain the employment status, the employee is bound to perform. This has the effect of discouraging risk aversion in the sense that for high returns the employee needs to be a risk lover in order to maximize revenue.

Another policy incorporated in the contract design in order to discourage risk aversion is the provision of incentives. The most common incentive is the bonuses. Under such a contractual arrangement the employee usually receives a monetary compensation in addition to the salary. This is given as a token for good performance. The employees who do not meet the criteria set in the contract for eligibility to receive the bonus do not receive the bonus. This ensures only the hardworking employees are rewarded. This helps to create competition in a firm. The competition is constructive to the firm in the sense that the productivity will be enhanced across all workers in their endeavor to receive the bonus. It also has the effect of discouraging risk aversion as all employees will employ the techniques that bring high returns to the firm. Risk aversion brings low returns hence it will be unpopular among workers desiring to qualify for the bonus.

Another contract design policy that helps to align the interests of the workers to the interests of the shareholders is the use of seniority wages. This is the payment of higher salaries for the members higher in the management hierarchy. Initially the workers are hired at a lower rate. As their productivity increases, they demonstrate their value to the company. Consequently their rank in the company rises and so does their salary. This motivates the workers to be aggressive in order to be more productive therefore rising in rank. It also creates healthy competition in the firm and this has the effect of discouraging risk aversion.

Finally another common policy which is modeled into the contract to discourage risk aversion is the use of non-monetary incentives. This includes awards and honors, promotions and recommendations. The criteria for eligibility for each of these rewards, is clearly laid down in the contract. The awarding of these rewards may be based on performance, consistency and innovation in the respective fields. Such awards usually earn an employee peer respect and are also of a great advantage in a case where the worker wants to seek employment in another company. Therefore, a worker can do all possible in order to qualify for the award e.g. the employee of the year award. Other than creating competition in a company, such incentives also encourage workers to be more productive as they will be recognized. Consequently risk aversion is discouraged in the employees, since they seek maximum productivity, which is only achievable through high return but high risk methods otherwise unpopular with risk averse employees.