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

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  • Qi Liu

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  • 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.

Suggested Citation

  • Qi Liu & Bo Sun, 2016. "Relative Wealth Concerns, Executive Compensation, and Systemic Risk-Taking," International Finance Discussion Papers 1164, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgif:1164
    DOI: 10.17016/IFDP.2016.1164
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    File URL: http://www.federalreserve.gov/econresdata/ifdp/2016/files/ifdp1164.pdf
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    References listed on IDEAS

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    1. Abel, Andrew B, 1990. "Asset Prices under Habit Formation and Catching Up with the Joneses," American Economic Review, American Economic Association, vol. 80(2), pages 38-42, May.
    2. Emre Ozdenoren & Kathy Yuan, 2017. "Contractual Externalities and Systemic Risk," Review of Economic Studies, Oxford University Press, vol. 84(4), pages 1789-1817.
    3. Fabio Feriozzi, 2011. "Paying for observable luck," RAND Journal of Economics, RAND Corporation, vol. 42(2), pages 387-415, June.
    4. Florian Hoffmann & Sebastian Pfeil, 2010. "Reward for Luck in a Dynamic Agency Model," Review of Financial Studies, Society for Financial Studies, vol. 23(9), pages 3329-3345.
    5. Chaigneau, Pierre & Sahuguet, Nicolas, 2013. "The effect of monitoring on CEO pay practices in a matching equilibrium," LSE Research Online Documents on Economics 55405, London School of Economics and Political Science, LSE Library.
    6. Paul Oyer, 2004. "Why Do Firms Use Incentives That Have No Incentive Effects?," Journal of Finance, American Finance Association, vol. 59(4), pages 1619-1650, August.
    7. Salvatore Miglietta, 2014. "Incentives and Relative Wealth Concerns," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 4(04), pages 1-34.
    8. Marianne Bertrand & Sendhil Mullainathan, 2001. "Are CEOs Rewarded for Luck? The Ones Without Principals Are," The Quarterly Journal of Economics, Oxford University Press, vol. 116(3), pages 901-932.
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    More about this item

    Keywords

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

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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