Relative Wealth Concerns, Executive Compensation, and Systemic Risk-Taking

Liu, Qi; Sun, Bo

doi:10.17016/IFDP.2016.1164

Working Paper

Relative Wealth Concerns, Executive Compensation, and Systemic Risk-Taking

Abstract: Given the recent empirical evidence on peer effects in CEO compensation, this paper theoretically examines how relative wealth concerns, in which a manager?s satisfaction with his own compensation depends on the compensation of other managers, affect the equilibrium contracting strategy and managerial risk-taking. We find that such externalities can generate pay-for-luck as an efficient compensation vehicle in equilibrium. In expectation of pay-for-luck in other firms, tying managerial pay to luck provides insurance to managers against a compensation shortfall relative to executive peers during market fluctuations. When all firms pay for luck, we show that an effort-inducing mechanism exists: managers have additional incentives to exert effort in utilizing investment opportunities, which helps them keep up with their peers during industry movements. In addition, we show that compensation arrangements involving pay-for-luck that are efficient from the shareholders? perspective can nonetheless exacerbate aggregate fluctuations in the real economy by incentivizing excessive systemic risk-taking, especially in periods of heightened risk.

Keywords: Relative wealth concerns; Managerial compensation; Pay-for-luck; Excessive risk-taking;

JEL Classification: D82; D86;

https://doi.org/10.17016/IFDP.2016.1164