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Dealing with Overleverage: Restricting Leverage vs. Restricting Variable Compensation

Author

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  • Pedro Gete

    (IE Business School, Maria Molina 12, 28006 Madrid, Spain)

  • Juan-Pedro Gómez

    (IE Business School, Maria Molina 12, 28006 Madrid, Spain)

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.

Suggested Citation

  • Pedro Gete & Juan-Pedro Gómez, 2018. "Dealing with Overleverage: Restricting Leverage vs. Restricting Variable Compensation," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 8(01), pages 1-29, March.
    • Handle: RePEc:wsi:qjfxxx:v:08:y:2018:i:01:n:s2010139218500015
    DOI: 10.1142/S2010139218500015
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    Cited by:

    1. Eberhard Feess & Ansgar Wohlschlegel, 2018. "Bank capital requirements and mandatory deferral of compensation," Journal of Regulatory Economics, Springer, vol. 53(2), pages 206-242, April.
    2. Chakraborti, Rajdeep & Dahiya, Sandeep & Ge, Lei & Gete, Pedro, 2024. "A model of managerial compensation, firm leverage and credit stimulus," Journal of Financial Stability, Elsevier, vol. 72(C).

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    More about this item

    Keywords

    Executive compensation; leverage; moral hazard; overborrowing; optimism;
    All these keywords.

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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