Competition for Managers, Corporate Governance and Incentive Compensation

Abstract

We propose a model in which firms use corporate governance as part of an optimal compensation scheme: better governance incentivizes managers to perform better and thus saves on the cost of providing pay for performance. However, when managerial talent is scarce, firms compete to attract better managers. This reduces an individual firm's incentives to invest in corporate governance because managerial rents are determined by the manager's reservation value when employed elsewhere and thus by other firms' governance. In equilibrium, better managers end up at firms with weaker governance, and conversely, better-governed firms have lower-quality managers. Consistent with these implications, we show empirically that a firm's executive compensation is not chosen in isolation but also depends on other firms' governance and that better managers are matched to firms with weaker corporate governance.

Keywords: corporate governance, executive compensation, externalities

JEL Classification: D82, G21, G18