Compensation and Risk: A Perspective on the Lake Wobegon Effect

28 Pages Posted: 7 Sep 2019

See all articles by Jiangyuan Li

Jiangyuan Li

Singapore Management University, Lee Kong Chian School of Business, Students

Jinqiang Yang

Shanghai University of Finance and Economics

Zhentao Zou

Wuhan University - Economics and Management School

Date Written: August 3, 2019

Abstract

We investigate an alternative economic channel of a positive relationship between risk and compensation, as documented by Cheng, Hong, and Scheinkman (2015). We propose that when information asymmetry exists, firms generally seek to use compensation as a signal of their CEOs’ ability. The risks arising from information asymmetry tend to encourage firms to pay higher compensation to their CEOs in a pattern of financial incentives we call the “Lake Wobegon effect”. However, when individual firms pursue complete signaling, a higher equilibrium compensation level can be achieved. This paper explores the factors that give rise to the “Lake Wobegon effect” and the learning process by which this effect can be counterbalanced over time(Hayes and Schaefer 2009).

Keywords: Compensation, Risk, Asymmetric Information, Learning, Belief

JEL Classification: D83, G44, J33

Suggested Citation

Li, Jiangyuan and Yang, Jinqiang and Zou, Zhentao, Compensation and Risk: A Perspective on the Lake Wobegon Effect (August 3, 2019). Journal of Banking and Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3447754

Jiangyuan Li (Contact Author)

Singapore Management University, Lee Kong Chian School of Business, Students ( email )

469 Bukit Timah Road
Singapore
Singapore

Jinqiang Yang

Shanghai University of Finance and Economics ( email )

777 Guoding Road
Shanghai, P.R.China, AK Shanghai 200433
China

Zhentao Zou

Wuhan University - Economics and Management School ( email )

Hubei
China

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