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

46 Pages Posted: 23 May 2016

See all articles by Qi Liu

Qi Liu

Peking University - Department of Finance

Bo Sun

University of Virginia Darden School of Business

Date Written: 2016-05

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

Suggested Citation

Liu, Qi and Sun, Bo, Relative Wealth Concerns, Executive Compensation, and Systemic Risk-Taking (2016-05). FRB International Finance Discussion Paper No. 1164, Available at SSRN: https://ssrn.com/abstract=2782288 or http://dx.doi.org/10.17016/IFDP.2016.1164

Qi Liu (Contact Author)

Peking University - Department of Finance ( email )

Beijing
China

Bo Sun

University of Virginia Darden School of Business ( email )

100 Darden Blvd
K, VA 22903
United States
8622453813 (Phone)

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
106
Abstract Views
856
Rank
385,948
PlumX Metrics