Scaling Laws, Talent Amplification, and Executive Compensation in the Commercial Bank Industry

Article excerpt

Abstract

This research takes an alternative approach in analyzing the distribution of executive compensation in the commercial banking industry. We make use of scaling laws-laws often applied in the physical sciences that relate the intensity of an event to its frequency-to quantify the distribution of compensation and to make inferences on the type of process that generates it. We find that the distribution of compensation for chief executive officers, chief financial officers and chief operating officers is consistent with the amplification of managerial talent. However, we find that senior lending officer compensation does not support such increasing returns to talent. (JEL G210, Y330)

Introduction

In this paper, we examine the structure of executive compensation in the context of the commercial bank industry. We model the distribution of compensation and make inferences on the dynamic process that generates it through the use of scaling laws-laws often applied in the physical sciences that relate the intensity of an event to its frequency. Scaling laws have been used to enhance our understanding of financial asset returns, income distribution, earthquakes, information dynamics, and other phenomena in the social and physical sciences.1 We are pursuing this alternative approach to executive compensation because standard structural models appear to have limited explanatory power. Clearly managerial quality should be positively related to managerial compensation, but even managerial quality is not strongly related to conventional measures of firm performance.2 Managerial talent is inherently of a dynamic character, and this is why we are employing an alternative empirical method to allow explicitly for complex dynamics in the determination of executive compensation.

As discussed in detail by Rhoades (1997), the commercial banking industry provides an excellent laboratory in which to pursue topics in applied microeconomics. The commercial bank industry has been especially dynamic in recent years with 6,300 bank mergers, 1,500 bank failures, 3,200 newly chartered banks, 28,000 branch openings, and 13,000 branch closings in the interval 1980-94 (Rhoades 1997, p. 2). Although this paper's focus is on the distribution of executive compensation in the commercial banking industry, the application of scaling laws is not specific to the banking industry or to executive compensation. We are choosing to focus on this particular aspect of the banking industry since this permits us to contrast our empirical findings with many recent studies on bank officer compensation that have appeared in the literature.

Numerous theories of executive compensation have appeared in the literature recently. Many of these theories focus on explaining the magnitude of executive compensation relative to the average worker's compensation. For example, Murphy (1985) proposes that some executives are extraordinarily productive so their compensation reflects this, and Lazear and Rosen (1981) propose a tournament model in which workers compete for the compensation of the CEO. Jensen and Murphy (1990) argue that executive compensation is not responsive enough to firm performance, and this argument is carried further by Crystal (1993) in arguing that executive compensation is determined by the executives themselves. However, studies of compensation in the banking industry have shown that the pay-performance linkage has become stronger after deregulation (Crawford et al. 1995; Hubbard and Palia 1995). Other compensation studies have examined empirically specific issues related to managerial compensation in particular industries, such as Joskow et al.'s (1996) study of compensation in the regulated utility industry, or Rose and Shepard's (1997) paper testing the managerial entrenchment theory against an alternative theory of executive talent.

Our empirical results indicate that the distribution of compensation for chief executive officers, chief financial officers, and chief operating officers is consistent with increasing returns to managerial ability. …