Dealing with Overleverage: Restricting Leverage vs. Restricting Variable Compensation

Pedro Gete and Juan-Pedro Gómez
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Juan-Pedro Gómez: IE Business School, Maria Molina 12, 28006 Madrid, Spain

Quarterly Journal of Finance (QJF), 2018, vol. 08, issue 01, 1-29

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.

Keywords: Executive compensation; leverage; moral hazard; overborrowing; optimism (search for similar items in EconPapers)
Date: 2018
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Working Paper: Dealing with Overleverage: Restricting Leverage vs. Restricting Variable Compensation (2017)
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DOI: 10.1142/S2010139218500015

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