Dealing with Overleverage: Restricting Leverage vs. Restricting Variable Compensation

Gete, Pedro and Gomez, Juan Pedro (2017): Dealing with Overleverage: Restricting Leverage vs. Restricting Variable Compensation. Forthcoming in: Quarterly Journal of Finance

Abstract

We study policies that regulate executive compensation in a model that jointly determines executives effort, compensation and firm leverage. The market failure that justifies regulation is that executives are optimistic about asset prices in states of distress. We show that shareholders propose compensation packages that lead to socially excessive leverage. Say-on-pay regulation does not reduce the incentives for leverage. Regulating the structure of compensation (but not its level) with a cap on the ratio of variable-to-fixed pay delivers the right leverage. However, it is more efficient to directly regulate leverage because restricting the variable compensation impacts managerial effort more than if shareholders are free to design compensation subject to a leverage constraint.

• Item Type: MPRA Paper
• Language: English
• Keywords: Executive Compensation; Leverage; Moral Hazard; Overborrowing; Optimism.
• Subjects: D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D86 - Economics of Contract: Theory; G - Financial Economics > G2 - Financial Institutions and Services > G20 - General; G - Financial Economics > G2 - Financial Institutions and Services > G28 - Government Policy and Regulation

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