Friday, October 9, 2009

The Inconvenient Truth of CEO Pay

In the following commentary, David Yermack makes a case against the regulation of CEO pay, arguing that the incidences of abuse are few, compared to the vast majority of properly functioning pay schemes.

Setting aside the argument that regulation is a blunt instrument that may lead to net losses in economic welfare, the research has clearly demonstrated a lack of a correlation between firm performance and CEO pay. Many cite this as the reason to regulate the latter.

It's not so simple.

What is 'excessive' CEO pay?

There has yet to be a compelling economic argument for why CEO pay is 'excessive'. Compensation is not a monolithic construct. Any compensation package includes pay for services, social capital (a CEO's reputation may add brand value to the firm), performance above expectation, and risk taking. Pay is wage, incentive and reward all mixed up. More critically, a CEO's performance is not the same thing as firm performance. While there may be some connection between pay and firm performance, it is normatively weak.

Is regulation the best approach?

No amount of regulation can anticipate the endogenous and exogenous contingencies and the interactions that drive firm performance. Hence, no regulation can contemplate the fine grained decisions involved in pay setting. There are best made close to the conditions on the ground, in the boardroom.

There is also an argument that replacing the informal institutions of shareholder activism and board decision making with the formal institution of regulation will further divorce directors from their sense of fiduciary. The net impact may be more abuse. It is not coincident that the increase in the complexity of the tax code is correlated with the increase in tax fraud.

The media loves to instigate popular sentiments against 'excessive' pay because they have economic incentives to do so. It is also understandable opportunistic politicians would jump on that bandwagon. As a thinking citizenry, we should know better. The genie of regulation, once out of the bottle, extracts a hefty price and cannot be tamed.

Better that we find ways to hold the directors accountable than for the government to set pay.

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