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Board of Governors of the Federal Reserve System (U.S.)
International Finance Discussion Papers
Relative Wealth Concerns, Executive Compensation, and Systemic Risk-Taking
Qi Liu
Bo Sun
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.


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Qi Liu & Bo Sun, Relative Wealth Concerns, Executive Compensation, and Systemic Risk-Taking, Board of Governors of the Federal Reserve System (U.S.), International Finance Discussion Papers 1164, May 2016.
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Keywords: Relative wealth concerns ; Managerial compensation ; Pay-for-luck ; Excessive risk-taking
DOI: 10.17016/IFDP.2016.1164
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