Seeking Alpha: Excess Risk Taking and Competition for Managerial Talent Acharya, Pagano and Volpin Comment Alan Schwartz

The Paper 1. The question is “what market failure produced excessive rewards for short-term performance at the expense of long-term risk?” 2. “For instance, a trader in a financial firm may set up a ‘carry trade’ and then leave the firm before it can be determined” if the trade could seriously fail or not. 3. “… managers who take long-term risks while moving rapidly between firms raise their short- term performance and pay, while reducing their accountability for failures.” 2

4. A completed project (a) generates a return; and (b) reveals the ability of its manager if the manager completes it. Hence, the manager bears the risk that “everyone” will know that he has low ability. 5. If the manager moves before completion, in a competitive labor market, he is paid his expected value, which is less than his value if he is revealed to be good but more than his value if he is revealed to be bad. 5. The market wage thus reduces the variance between the reward for revealed good managers and revealed bad managers. Hence, a risk averse manager has an incentive to choose a project that is a potential home run and move before the market learns he may have struck out. 3

6. The incentive of managers to act this way is increasing in the manager’s risk aversion, and in the opacity of projects (as regards what projects reveal about managerial talent). 7. The risk averse manager thus has an incentive to choose risky, hard to evaluate projects with long-term payoffs, and insure himself by moving to another firm. The major inefficiency is that managers can get to manage projects that require talent they lack. 8. The best way to prevent too many project failures is to restrict managerial movement. Then managerial talent is revealed for sure. 9. The problems explicated here are said to correspond to some financial market behavior. 4

The Explanation 1. My principal comment is that the model apparently does not correspond very closely to the motivating story. 2. In the model, each firm can pursue a safe project or a risky project. The safe project has a lower net return than the risky project. There are two manager types: G and B. Either type can generate the safe project return. 3. A risky project can generate a high return or a low return. The G manager generates the high return and a B manager generates the low return. 4. Efficiency requires that only G managers run risky projects. At the outset, however, no one knows whether a manager is G or B. 5

5. A firm offers a sequence of wages at the beginning of a period that “reflects the manager’s expected productivity in” that period. The wage “therefore is contingent on the project to which he is assigned and on his perceived quality” if he has worked before the current period. 6. “A firm’s strategy is a profit-maximizing choice of wage offers and project assignments.” 7. “Firms commit to pay the sequence of wages they have offered, but not to a specific project assignment: once the contract is agreed upon, the firm assigns the manager to whatever projects maximizes its expected profits.” 8. “The manager’s strategy consists in a period by period choice of employer”. Because firms are symmetric, the manager picks a firm in period one and then decides whether to stay until project completion and a second period, or to leave for another employer in period two. 6

9. In the model, the manager does not choose projects; the firm assigns projects to him. 10. The manager does not choose how much effort to invest in running a project or otherwise how to run it. Rather, a project’s outcome is a function of the manager’s type. 11. The manager’s only choice is whether to stay or to go. 12. The model thus apparently cannot explain the behavior of managers who choose excessively risky projects or who run risky projects carelessly, and who abandon projects before completion. 7

13. The paper thus apparently creates a very interesting task assignment model. Its contribution is to show that, under certain conditions, worker mobility reduces to below first best a firm’s ability to make efficient project assignments. 14. The paper also shows that worker mobility is an important function of worker risk aversion because mobility, when worker ability is initially unknown to firms or to workers, is a form of insurance. 15. These are neat contributions but they seem unrelated to the financial disasters that partly caused the great recession. 8

The Model: Generality 1. Manager Ability: The model applies well to investment or mutual fund firms, where relatively young employees are permitted to make trades or to create portfolios. At the outset, no one know whether such a worker is smart or lucky (or unlucky). Ability is inferred from a sequence of project returns. 2. In the model here, ability is learned with certainty and it never changes. The model’s results moderate, or can vanish, as more and more workers know their ability. 3. Regarding generality, consider a high standing engineering graduate who performs well on supervised tasks, and who, after several periods, is given a project to run. 9

4. Thinking a little formally, consider a model where the employee works for t 1, t 2, …T periods and then exits. His ability can take any level from a L to a H. Ability is an increasing function of periods worked. The worker, and the market, knows the worker’s ability at time t i with probability p(t i ); this probability also is an increasing function of time worked. 5. The illustrative engineer, and the market, thus may know the engineer’s ability with a nontrivial probability when he first gets a project to run. 6. Put generally, the managerial supply curve is composed of workers with varying abilities, and the market, at any time, knows these abilities with varying probabilities. Do the paper’s results hold in this world? 10

7. The Project: Partition a period into two sub-periods: an initial λ a and a λ b. The manager must work for all of λ a. Project success or failure is determined at the end of λ a. The manager then can leave (or stay) because the project “proceeds unsupervised” during λ b. 8. This model applies when the manager purchases a long term debt contract – a mortgage – in sub-period λ a because he won’t do anything in λ b. Consider instead a project that requires continuous supervision to succeed. 9. Let manager one leave after sub-period λ a. The market could not invert to develop a success probability for this manager just from the project’s results because the contribution of manager two also matters. 10. Manager one may do better staying for the entire period because otherwise his ability may never be revealed, or revealed with any precision. Do the paper’s insights also hold for labor markets in which projects require continuous supervision? 11

11. The market’s knowledge: In period one, the manager is assigned to a project. Suppose he leaves before the project is completed. In the model, the market infers his ability from: (a) the project’s result; (b) the unconditional probability of project success; (c) how the manager’s input affects success; (d) how revealing of managerial ability particular projects are (the β variable). 12. When firms are relatively homogenous, so that projects differ little across firms, the market can make accurate inferences. Firm B projects would be very similar to firm A projects. Because firm B can evaluate its own projects, it can evaluate the performance of a manager at firm A. 13. In this world, the manager’s human capital is essentially general. It is more common to assume that manager human capital, especially on decision making levels, has a substantial firm specific component. How well does the paper apply to managerial labor markets when human capital is both general and specific? 12

Conclusion 1. This paper has an elegant and interesting model. Its motivation is to explain some financial market behavior during the great recession (and today). I suggest that the paper is better understood as explaining firm project assignments when there is asymmetric information about worker ability and workers are highly mobile. This is a real contribution but perhaps the paper’s introduction should be modified. 2. However the paper is characterized, it makes some specific seeming assumptions. This raises the question about the width of the paper’s domain. The authors address the domain issue, but more apparently could be said here. 13