Management Accounting Section Midyear Meeting

Inside Debt and Agency Conflicts: Evidence from the Global Financial Crisis

• In Event: Incentives and Compensation I

Abstract

Evidence shows that managers’ debt-like compensation (i.e., inside debt) aligns their incentives with lenders’, reducing the agency cost of debt. We examine how changes in the contracting environment affect the effectiveness of inside debt. We focus on the Global Financial Crisis, which shocked the supply of bank lending capital and firms’ economic performance. We find evidence of reduced reliance on inside debt for debt contracting during the crisis, consistent with lenders demanding more protection from agency conflicts during the crisis. We further find a stronger association between inside debt and investment risk during the crisis, consistent with inside debt providing managers incentives to protect liquidation values. Evidence from the recovery period following the crisis shows that some of these changes persist even when lending and economic conditions recovered to pre-crisis levels. To generalize our results beyond the crisis, we examine firms in industries experiencing shocks to demand. We find some evidence that supports our main analysis. In total, the results suggest that the role of inside debt changes predictably with the contracting environment.

Authors

• Peter Demerjian, University of Illnois at Chicago

• Paige Harrington Patrick, University of Illinois at Chicago

• Frances Tice, University of Colorado Boulder