Chief Executive Compensation: An Empirical Study of Fat Cat Ceos

By Lin, Dan; Kuo, Hsien-Chang et al. | The International Journal of Business and Finance Research, April 1, 2013 | Go to article overview

Chief Executive Compensation: An Empirical Study of Fat Cat Ceos


Lin, Dan, Kuo, Hsien-Chang, Wang, Lie-Huey, The International Journal of Business and Finance Research


ABSTRACT

This paper empirically tests the determinants of executive pay. In order to gain more understanding of the fat cat problem that have been subject to hot debate, we also examine a sample firms that suffer from the "fat cat problem", defined as firms with poor performance while their Chief Executive Offers (CEOs) receive high compensation. Based on a sample of 903 US firms between 2007 and 2010, we find that there is a substitution effect between CEO compensation and the level of CEO ownership and that larger firms give higher pay to their CEOs. When the sample is limited to fat cat companies only, we find that tenure and firm size are significantly positively associated with CEO compensation. The firm size, leverage ratio and investment opportunities are found to be significantly associated with the CEO total compensation when the sample is limited to fat cat companies in the financial services industries. Overall, firm size appears to be the most important determinant of CEO compensation and that there is a general lack of linkage between pay and performance. The evidence thus calls for public attention for reexamining the effectiveness of current pay system.

JEL: G34, M52

KEYWORDS: Executive Compensation, Fat Cat, Pay-Performance Relationship

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

The issue of "fat cats" became a hot button issue during the recent financial crisis in 2007 and 2008. Blinder (2009) suggests that the "perverse" incentive built into the compensation plans of many financial firms is one of the most fundamental causes of the financial crisis and surprisingly receives little public attention. The incentives given to Chief Executive Officers (CEOs) and other top executives of large banks or investment banks have encouraged the excessive risk-taking by top managers, leading to the financial crisis. Most financial institutions link incentives of executives to short-term securities trading performance. Executives are encouraged to engage in short-term gambles and to focus their attention on short-term objectives instead of achieving sustainable growth objectives (Abou-El-Fotouh, 2010). Specifically, these institutions have failed to recognize that high incentives could lead to uncontrollable risks and this problem has been blamed for causing the financial crisis.

Additionally, there have been increasing concerns about the escalation in executive compensation (Dong & Ozkan, 2008). In particular, the substantial rises in executive pay have far exceeded the increases in underlying firm performance (Gregg, Jewell, & Tonks, 2005). The review on CEO compensation by Frydman and Jenter (2010) shows that there was a dramatic increase in compensation levels from the mid-1970s to the early 2000s in the US. Especially in the 1990s, the annual growth rates were more than 10% by the end of the decade. The increase in executive compensation was evident in firms of all sizes with larger firms experiencing even greater growth. The high level of CEO pay in the US has therefore brought about considerable debate and a lot of attention from academia and policy makers regarding executive compensation, in particular, the pay-setting process and the effectiveness of the compensation contracts.

In the US market, the regulations place a strong emphasis on shareholder protection and information disclosure. As a result, most US firms are characterized by dispersed share ownership and low managerial ownership (Core, Guay, & Larcker, 2003). Compensation contracts therefore become particularly important in aligning the interests of managers and shareholders. The level of executive compensation and the linkage between compensation and firm performance have been extensively researched while no consistent results have been reported. For example, studies by Murphy (1985), Jensen and Murphy (1990), Hubbard and Palia (1995), and Ozkan (2011) all find a positive relation between pay and performance, supporting the agency theory. …

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