An Evaluation of Public Sector Enterprises Finance Essay

One of the reasons why the financial crisis has led to such negative consequences for the world economy is pay-for-performance systems that were being used in financial institutions. In order to prevent this scenario from happening again, financial regulators have developed remuneration rules and guidelines that aim to mitigate the negative consequences that are associated with bonus schemes (e.g., CEBS high-level principles of remuneration policies, the Statement on Director Remuneration of the European Corporate Governance Forum, the British Financial Services Authority's code on remuneration practices, the Netherlands Bankers' Association code). Common for all of these recommendations are deferral of bonus payments and bonus caps. Although many authors have been exploring this concrete field, the impact of deferred payment is yet considered as very complex and not fully understood. Amongst the total set of recommendations that these codes provide, two specific recommendations, which are central to all codes, are to cap bonuses and to defer bonus payments. At the same time, academy and practise are discussing about effectiveness of public sector enterprises.

A 2005 Organisation for Economic Co-operation and Development (OECD) report noted the significant evolution and reform since 1995 of the government ownership function. These reforms have tended to move countries away from the decentralized model and more toward the centralized model of governing of public sector or state-owned enterprises. The effectiveness and performance of an enterprise is  as the degree to which the objectives assigned to it by its owners can be reached. The objectives of the private enterprise owners come down in large measure to a single objective, maximization. The objectives of public enterprises are more numerous. Public sector enterprises besides commercials goals are structured to fulfill social goals. In order to evaluate performances of those enterprises, state ownership authorities needs to implement social component of its business into performance management system.

3. PROBLEM DEFINITION

Managerial payment incentives are being used in corporations that are strictly commercially oriented, but also in public sector enterprises. Do the same payment incentives in commercially oriented corporations and public sector enterprises lead to the same managerial decisions? Do they encourage the same level of risk-taking? State ownership authorities are supervisory and monitoring bodies that govern the state shareholdings. In order to evaluate performances of state asset that is in their jurisdiction they need performance measurement tool that can implement social specificity of public sector enterprises. The aim of research is to develop balanced score card model for public sector enterprises. Ho: Same type of managerial payment incentives has different influence on managers in financial institution and public sector enterprises Ho: Does deferred bonus payment affect decision makers' in public sector enterprises preference for risk? Ho: Does deferred bonus payment affect decision makers' in public sector enterprises preference changes in risk preference based on prior outcomes? We test these predictions in a two-by-two between subject experiment that involves a choice task. In the experiment, subjects were presented with the asset allocation task between two alternative investments - a risk free and a risky asset - repeated in two stages under four possible combinations of bonus schemes.

The prospect theory that convincingly describes decision taking in one period may however not be extended to intertemporal decision choices. Such is the case when bonuses are deferred and decision making in one period affects the outcomes in several subsequent periods. The study will start on the premise that managers evaluate a certain income as a gain or a loss depending on the reference point. Managers are risk averse when the choices are made in the gain domain and loss averse (which may mean risk seeking) if the choices are made in a loss domain. The prospect theory that convincingly describes decision taking in one period may however not be extended to intertemporal decision choices. Such is the case when bonuses are deferred and decision making in one period affects the outcomes in several subsequent periods. Moreover, the bonus that is not received immediately gets discounted. Results and conclusions of dissertation should contribute to the implementation of pay schemes into the practice that would lead to optimal and functional risk propensity of managers in public sector enterprises. Also, it should contribute to better performance evaluation of public sector enterprises.

4. CRITICAL LITERATURE REVIEW

Monetary incentive structure has role to aim managerial behavior to maximize firm value (Jensen and Murphy, 2004). Traditional pay-for-performance schemes do not obtaining that goal, because they represent option contracts rewarding positive outcomes more than punishing negative outcomes. This asymmetry is considered as important source of managerial dysfunctional risk-seeking behavior (Chen, Steiner and Whyte, 2006). As a response to regulatory recommendations and pressures major banks have suggested linear compensation schemes which symmetrically reward and punish managers for decision outcomes (Byrnes, 2009). However, the estimated risk-seeking effects of those schemes depend on the expected utility that decision makers appoint to these positive and negative outcomes (Kahneman and Tversky, 1979). In contrast with expected utility theory, prospect theory argues that the utility of a cash flow depends on whether decision makers perceive the cash flows that is formed due to their decision as a gain or a loss. Whether cash flows are perceived as a gain or a loss depends on individuals' reference points when evaluating decision outcomes (Kahneman and Tversky, 1979). In general, losses weigh heavier than gains. This asymmetry causes people to be more risk averse in the gain domain than in the loss domain. Prospect theory is a descriptive theory based on evidence from gambling experiments.

t argues that individuals' behavioral patterns can be described by assuming they have utility curves in their minds which vary between domains. Prospect theory does not explain what reference point people take. It assumes that people take a reference point, after which the curves explain their risk preferences. An important distinctive element of the capped versus the non-capped scheme is the potential of a loss. Previous results suggest that an individual is slightly risk averse for gambles involving only gains, but strongly risk averse for gambles that cause potential losses (Schoemaker, 1990; Thaler, Kahneman, Tversky & Schwartz, 1997). This would imply that agents with the non-capped scheme may want to evade penalties by taking a less risky strategy than those with the capped bonus scheme. It is difficult to imagine how a negative bonus would be enforced in practice other than subtracted from the prior balance of bonuses or from the fixed pay. To this point, just few penalty provisions are contained in the compensation contracts. In previous research penalties were in majority of experiments only hypothetical (Camerer, 1995), not enforced (Schoemaker, 1990) or expressed as opportunity costs withheld from the overall payment (Thaler, 1981).

A scheme that is framed as a penalty in terms of opportunity costs is most likely to be used in real compensation contracts. The managers risk preference will depend on his perception of the remuneration as a loss, a gain or a reduction in a gain. The perception of the non-capped scheme as a mixed loss-gain domain or only a gain domain (as defined by Thaler, Kahneman, Tversky & Schwartz, 1997) depends on whether the agent will revise the decision problem. A manager could consider entirely the effect of the decision taking on the bonus. In that case, the fixed pay would not influence a decision, but would be cancelled out as common effect for any choice. According to such editing of the problem, the non-capped bonus scheme is likely to induce risk aversion to avoid a loss. Or, in another case, a manager may reflect on the effect of decision taking on his overall bonus. A larger fixed pay in contrast to a variable pay would make the estimated value of the total compensation positive. If such editing is adopted, then a non-capped scheme in contrast to a capped scheme may result in higher risk propensity as it may give managers the potential for higher returns.

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