Schweser QB # 47079

In which of the following situations is the board of directors most likely to become more effective? A) The economy is in a recession and the firms stock price has been consistently declining. B) The firm has sustained several quarters of losses and the firms stock price has been consistently declining. C) The firms earnings have been increasing and the stock price has been consistently increasing. D) The economy is in an expansion and the firms stock price has been consistently increasing. Answer is B. Why not A? If the firms earnings have been consistently decreasing, the firm is likely nearing crisis. Boards become more active during periods of crisis or when the stock price declines. It is at these times when the personal relationship between managers and directors deteriorates and that boards find themselves in the public limelight

I remember this question and here was my logic: When the economy’s in a recession its not the board’s fault, therefore they are less likely to become more effective than if the company has sustained several quarters of losses (as company losses ARE the boards fault - this ties into behaviour bias). A declining stock price is the realization of poor performance. So A is eliminated. C and D are eliminated, as you likely concluded, because when things are going well, little changes in the way of increased accountability or effectiveness…

striker put it right, i just wanna add…(from wsj) Why Banks Need Pay Fix Compensation Practices Lack Teeth to Penalize Traders Who Lose Big March 11, 2008; Page C14 Bankers’ pay must be regulated. The industry’s one-way incentive structures have led bankers to run amok with other people’s money – contributing to the chaos in financial markets. When their bets pay off, bankers and traders carry home massive bonuses. When the bets crater, they don’t hand those bonuses back. If bankers aren’t forced to face the full consequences of their folly, the current mess will be repeated. Sure, there has been uproar. Former Merrill Lynch and Citigroup bosses Stan O’Neal and Charles Prince, respectively, along with Countrywide Financial’s Angelo Mozilo, faced tough questions on Capitol Hill on Friday. But the solution isn’t for the government to micromanage pay. Regulators don’t have the expertise. Rather, the way forward is to set a general principle that “heads-I-win-tails-you-lose” compensation structures are unacceptable. Many on Wall Street and in the City of London say regulators have no business even setting general principles. Shareholders lose out when the banks in which they invest take silly bets, and they will get around eventually to controlling the madness. This argument is self-serving. Shareholders do suffer when traders run up billions of dollars of losses. But they don’t face the full pain – any more than traders do. The authorities almost always can be counted upon to rush to the rescue, with implications that go far beyond shareholder rosters. That is what we are witnessing now. Central banks around the world have been pumping liquidity into the financial system, enabling banks to raise cash against assets they otherwise would be hard-pressed to sell. This risks stoking inflation, inflicting pain on ordinary savers. Without these initiatives, many banks probably would have folded. As it is, the bonuses have kept rolling and most shareholders still are receiving dividends, albeit reduced ones in some cases. It also is naive to suppose that the industry will reform itself. Wall Street apologists argue that if Bank A doesn’t pay top dollar, it will lose its best traders to Bank B. That is the weakness of voluntary industrywide codes of conduct, like the one floated last week by the Institute of International Finance, a bankers’ talking shop in Washington. But step one is indeed some sort of code. Regulators should establish loud and clear that one-way bets are unacceptable. Bank compensation committees should be required to verify that they are adhering to this central principle, including the notion that top managers should be fired, not allowed to retire, if it is violated. There also should be noncompulsory guidelines on best practice. For instance, it is asking for trouble when a trader gets all his bonus in cash based on his success trading in a single year – whether or not his positions later incur losses. Healthier compensation structures should normally have three elements. First, a large chunk of any bonus above a modest size should be paid in equity, so that bankers have an interest in their colleagues’ behavior. Second, equity should vest over several years to ensure that bankers worry about the longer term. Third, part of the bonuses earned each year should be put in escrow – with the understanding that it will be clawed back if the recipients post losses in subsequent years. At the same time, regulators on both sides of the Atlantic should collect and publish information on how compensation is, in practice, structured. That would inform the debate and encourage banks to adhere to best practice, for fear of being named and shamed. If these measures were adopted, bank bosses would know that they would face significant financial pain if their institutions messed up. And, given that the whole industry would be regulated in this way, the competitive pressure to adopt the lowest common denominator compensation program would be reduced. Last week, Congress grilled Wall Street bigwigs over pay. Next time, it should haul in the regulators.