Competition for Talent and Cyclical Malpractice in Corporate Governance

Abstract

We present a model that rationalizes the cyclical nature of executive compensation and malpractice. The model features a principal-agent setting where effort and misreporting incentives are at conflict and managerial talent is a scarce asset. In the optimal contract, investors exploit a combination of short-term bonuses and investment in monitoring, but competition for managerial talent exacerbates malpractice and increases incentive pay. Malpractice dampens the efficient reallocation of assets, which supports regulations that modulate executive pay and corporate governance. Embedded into a dynamic general equilibrium with household savings and endogenous rates of return, the model reproduces the build-up of malpractice during expansions and its reduction after declines in aggregate output.

Keywords: Executives, Governance, Compensation, Malpractice, Cycles

JEL Classification: G34, G35, E32