The prevention of excess managerial risk taking

Executives with poor prior performance may be inclined to take excessive risk in the hope of meeting performance targets, in which case a compensation contract featuring severance pay can be optimal. While prior work has shown that severance can induce managers to take positive NPV risks, we show that it can also keep them from taking negative NPV risks. We show that severance should be contingent on results: complete failure should nullify any payments. We also show that mandating a firm size that is larger than first-best, while costly, can help screen for good managers.