Hypotheses - Effects of remuneration systems on performance and other incentive mechanisms in corporate governance

Table: Hypotheses - Effects of remuneration systems on performance and other incentive mechanisms in corporate governance

Click here to see an exhibition on these issues and their relation to other hypotheses in corporate governance.

6) From incentive based compensation to financial performance

6A: Incentive correlation argument: Remuneration systems that correlate the management’s salary with financial performance may motivate them to increase financial performance (Hart and Holmström [1987, part 1]).

6B: Incentive correlation incentive crime argument: Remuneration systems that correlate the management’s salary with financial performance may motivate incompetent and opportunistic managers to use their power to fake the earnings of the firm they manage. Forging the accounts is not possible in the long-term so although in the short-term this kind of argument should cause managerial salary and financial performance to be positively correlated in the long-term the effect should be highly significant and negative. The latter is also the case because the management is assumed to be incompetent and the longer they stay in power the more money the firm will loose. Furthermore, it should be expected that countries that do not have a legal system that punishes this kind of managerial fraud heavily should suffer more from this kind of crimes.

6C: Compensation level argument: Higher managerial compensation may result in higher financial performance because higher wages are able to attract the most competent managers.

6D: Rent extortion argument: All managerial compensation decreases financial performance simply because it ceteris paribus reduces the residual profits. Extraordinarily high managerial remuneration may therefore have a significant and negative effect on the overall financial performance.

6E: Fat wallet no care argument: Very high levels of managerial compensation cause the managers to become too rich too fast to care about continuing to work hard to keep his/her job.