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Executive Compensation and Firm Leverage. A Policy Oriented Survey

This paper surveys the literature that studies the connection between leverage and executive compensation. First, we discuss the dynamics of pay-for-performance compensation and how to measure it. Then we study the theoretical underpinnings of how firm leverage may be related to the compensation structure of its executives. After reviewing the empirical work on the topic we survey the policy implications. We discuss recent work that shows positive outcomes from regulating executive compensation, but that raises a cautionary note: regulating leverage directly seems more efficient than regulating executive compensation.


EXECUTIVE COMPENSATION AND FIRM LEVERAGE. A POLICY ORIENTED SURVEY
This paper surveys the literature that studies the connection between leverage and executive compensation. First, we discuss the dynamics of pay-for-performance compensation and how to measure it. Then we study the theoretical underpinnings of how firm leverage may be related to the compensation structure of its executives. After reviewing the empirical work on the topic we survey the policy implications. We discuss recent work that shows positive outcomes from regulating executive compensation, but that raises a cautionary note: regulating leverage directly seems more efficient than regulating executive compensation.
Following the 2008 financial crisis, there has been a lively debate in the academic and policy circles about regulating executive compensation to avoid excessive firms' leverage.
Some countries have regulated the structure or the level of compensation, especially for financial firms, while others have adopted say-on-pay regimes that increase shareholder's weight in the design of executive compensation.
For example, the European Union (Directive 2013/36/EU and CRDIV) has established that bonuses at credit institutions and investment firms cannot exceed 100% of fixed salary (200% if the company wins shareholder approval). The U.S. is also discussing new rules to curb executive compensation in financial institutions [Wall Street Journal (2016)]. Correa and Lel (2016) document that eleven countries have passed laws to give shareholders direct influence on executive compensation policies (i.e., say on pay laws). In Spain, the "Ley de Sociedades de Capital" regulates executive compensation. 1 For public companies, the "Código de Buen Gobierno" approved in 2015 by the Spanish Securities and Exchange Commission (CNMV) recommends the use of deferred compensation and clawbacks clauses.
In this article, we discuss the literature that studies the connection between firm leverage and executive compensation. Our survey is selective and guided by two policy questions.
First, we study the effects of executive compensation on firm's leverage. We focus on whether the structure of compensation affects the willingness to borrow following a credit stimulus. Governments and central banks often try to stimulate economic activity by promoting credit supply. This is referred to as monetary policy's risk-taking channel. It was especially important during the Great Recession because, once the policy rates hit the zero-lower bound, many Central Banks resorted to unconventional policies to lower banks' borrowing costs and expand credit supply [Correia et al. (2016), Gambacorta and Shin (2016)]. The literature has focused on what types of lenders react more. 2 In this article, we discuss papers that focus on the borrowers, which is a relatively unexplored question. This work can help us understand in what settings the credit expansion policies of Central Banks may have the maximum impact.
Second, we discuss recent work that studies when and how executive compensation should be regulated. The literature suggests that it may be more effective to directly limit leverage rather than trying to affect it indirectly by imposing limitations on executives' compensation.

Abstract 1 Introduction
In this section, we define how the literature measures pay-for-performance compensation.
After that, we discuss the dynamics of the structure of executive compensation. We use CEO and executives as synonyms. The key take-away is that pay-for-performance compensation has increased over time, especially since the mid-1980s.
In the literature, the executive's exposure to firm performance is called the pay-performance sensitivity. To understand better this concept, we consider a simple one period model inspired in Edmans and Gabaix (2016). The firm has no debt to simplify. Let S be the firm's equity value at the beginning of the period.
Let the CEO's compensation be c=F+S, where θ denotes the CEO's equity ownership in the firm. We assume risk-neutrality. In this case, the pay-performance sensitivity is θ, the variation in the executive's wealth when the stock's price changes. This measure is also known as the CEO's percentage stake. Jensen and Murphy (1990) estimate this sensitivity as follows: [1] ∆ denotes the stock option's delta. Delta measures the degree to which an option is exposed to shifts in the price of the underlying asset. Hall and Liebman (1998) show that the portfolio of unexercised stock options is the largest component in CEO's performancepay sensitivity. Estimating delta for this portfolio of options can be challenging since firms do not typically report the features of options granted in previous years, like their maturity or their strike price. Shareholders can manage executives' pay-performance sensitivity (the slope θ) by either granting more shares, more stock options or, in the case of options, through their delta. There is a positive relation between stock options' delta and payperformance sensitivity. The executive's risk exposure increases when the sensitivity increases.
For risk-averse CEOs we cannot ignore the effect of firm volatility on the executive's incentives. Instead of talking of the CEO's dollar pay we should talk about her certainty equivalent wealth, CE. Guay (1999) decomposes the executive's certainty equivalent wealth into two components: When the executive is risk neutral, the second element vanishes and we converge to the previous analysis. ∂∂∂ for outperforming certain benchmark and no (or limited) penalty in the case of underperformance also exhibit an option-like behaviour with respect to the volatility of firm cash flows; 3) in leveraged firm, common stock can be interpreted as a call option on the firm's cash flows with debt's face value as the strike price [Black and Scholes (1973) and Jensen and Meckling (1976)].
The second element in equation [3], , is called the risk-aversion effect.
When shareholders increase pay-performance sensitivity (θ in equation [1]), risk averse executives will demand a premium for bearing more firm-specific, non-diversifiable risk.
Equation [3] says that the size of this premium varies with the executive's sensitivity with respect to firm risk. This sensitivity is higher for non-diversified executives (i.e., when the CEO's compensation is a larger fraction of her total wealth) and for more risk averse executives.
In the case of options, Carpenter (2000) and Ross (2004) show theoretically that, due to the risk-aversion effect, higher stock volatility may actually decrease the value of options when options are deep enough in the money (i.e., when the price-to-strike price is large enough). This theoretical argument can be extended to any convex, option-like compensation structure, like common stock from a levered firm.

∂(risk premium)
∂ Table 1 shows the four key components of executive compensation: 1) Salary is fixed, non-contingent compensation; 2) Other components may include pension plans, insurance benefits and perquisites (like a club membership, for instance); 3) Bonuses are non-equity incentive plans based either on the board discretion or on the achievement of certain objectives. These objectives can be expressed in terms of accounting performance (like a target for earnings-per-share), market performance, or the relative ranking of the firm with respect to its peers; 4) The equity-based component includes stock option grants (at their Black-Scholes value) and stock grants (at their market value).  left axis is the change in dollar pay per 1% change in firm's value (dollar equity at stake).
The two lines differ because of the growth in firms' values over time. Executives tend to own smaller stakes in larger firms. As a result, firm's growth leads to higher equity-at-stake incentives. Both measures show an increase in pay-for-performance pay over time.
In this section we survey the theoretical literature studying the theoretical underpinnings of how a firm's leverage is related to the compensation structure of its executives. For a given level of compensation, when the variable share is larger we say that compensation is more convex, or has a higher pay-for-performance sensitivity.
We should mention that the literature we are reviewing in this section assumes the existence of an arms-length relationship between the CEO (the agent) and the compensation committee (representing the board and, ultimately, the shareholders). We could term this approach as the contractual approach. This is not the only view. Pioneered by the work of Bebchuck and Fried (2004), a strand of the literature challenges the arms-length assumption and argues that the observed contracts are not justified by firm performance or firm characteristics. This literature stresses rent extraction by CEOs interested in their own agendas.
Since the work of Jensen and Meckling (1976) and Holmstrom (1979), it is well understood that linking compensation to performance is a powerful instrument to align the interests of The seminal paper linking compensation structure and leverage is John and John (1993).
In this paper, the authors study a model that incorporates a moral hazard conflict between shareholders and executives. Higher delta in the executive's compensation may, as we have seen, align the incentives of both agents. On the other side, higher delta exacerbates the executive's risk appetite resulting into a risk-shifting conflict between shareholders and bondholders. Bondholders will discount this conflict pushing up bond premia. To mitigate the extra cost of debt induced by risk-shifting, the optimal compensation contract will reduce pay-performance sensitivity as firm's leverage increases.
Contrary to the risk-shifting incentives, Lambert, Larcker and Verrecchia (1991) show empirically that options may decrease incentives for risk-taking. Theoretically, the models of Carpenter (2000) and Ross (2004) predict that, for risk averse executives, higher stock volatility entail a negative risk-aversion effect which may dominate the wealth effect.
Confirming the previous prediction, Lewellen (2006) (2010) show that risk-averse managers more exposed to variable pay exhibit lower leverage.
The models proposed in all these papers provide arguments for why the level of leverage across different firms should be negatively related to the ratio of variable pay to the fixed 3 Compensation and Firm's Leverage. Theory component of the total CEO compensation. However, the empirical literature, reports conflicting findings on whether the correlation between pay-for-performance compensation and firm's leverage is positive or negative [Tosun (2015)]. Edmans and Gabaix (2016) discuss that the literature lacks a model in which leverage and compensation are jointly determined in a framework that allows for risk aversion, effort, risk taking and endogenous costs of borrowing.
Gete and Gomez (2017)  Simultaneously, as the manager is compensated with equity, the manager has more incentives to supply effort in a more leveraged firm.
Dahiya, Gete and Ge (2017) revisit the existing theory and by making effort, leverage and credit spreads endogenous, expands it with new insights. The authors describe an economy with one firm that is owned by a shareholder who in turn has to hire a CEO to run the firm. The model also has a lender from whom the CEO borrows. The CEO is risk-averse while the shareholder and the lender are risk-neutral. The firm is exposed to productivity shocks whose mean is increasing in CEO's effort. This effort is costly for the CEO and noncontractable. The CEO receives a compensation contract composed of a fixed part and a share of the firm's profits. She decides effort and leverage. The lender prices firm's leverage with an endogenous spread over its costs of funds to be compensated for the risk of default from the firm.
The paper shows that the sign of the cross-sectional correlation between the level of leverage and the structure of compensation depends on the interplay of three channels: a) More convex compensation encourages effort by exposing the CEO to the rewards from higher firms' profits (increasing the CEO's pay-for-performance sensitivity); b) Like in Gete and Gómez (2017), there is a complementarity between leverage and effort that encourages leverage. That is, more convex compensation induces higher effort and since this makes bad shocks less likely then leverage increases; c) When the CEO is risk-averse, more convex compensation discourages leverage. The basic trade-off faced by the CEO is the level of variable compensation to accept and how much to borrow. This arises because both of these factors are sources of risk for her. That is, her total compensation has higher variance when either pay-for-performance or leverage are larger.
Channels a) and b) above generate a positive cross-sectional correlation between the level of leverage and the degree of convexity of executive compensation. Channel c) induces a negative correlation. For plausible calibrations the authors find that, except when variable compensation or CEO's risk-aversion are small, channel c) dominates and the correlation between the level of leverage and pay-for-performance compensation is negative.
Interestingly, Dahiya, Gete and Ge (2017) predict that the relationship between the change in leverage and variable compensation is unambiguously positive after an expansive shift in credit supply. This happens because the variable component makes the CEO more exposed to firm's value. Since the credit subsidy generated from the monetary policy shift increases the value of the borrowing firm, its CEO will borrow more if she is promised a larger share of the firm (i.e. higher variable compensation).
Moreover, after expansive credit policies, the shareholder offers contracts with less variable pay. The shareholder understands that after the stimulus the CEO is supplying more effort and choosing higher leverage, which are complements, and sees less need to provide variable compensation to motivate the CEO.
Both compensation and firm's risk are endogenous. Thus, there are reverse causality problems. Variable compensation can encourage or discourage leverage for the reasons discussed above. However, it may also be the case that shareholders anticipate the risk conditions that the firm will face and design CEO's compensation to optimize their performance. Moreover, there may exist other reasons (omitted variables) that simultaneously drive compensation and risk-sensitivity. Thus, it is a difficult empirical problem to analyze whether compensation drives firm's risk. We review next how the literature has dealt with this problem.
Palia (2001) 2008Q4 to 26.2% in 2009Q1, and to 33.9% in 2009Q2. Ouyang and Peng (2015 state that "this was the biggest stimulus program in the world, equal to about the three times size of the U.S. effort." The literature agrees that nobody anticipated this large credit stimulus [Naughton (2009) and Deng et al. (2015)].
Dahiya, Gete and Ge (2017)  Gete and Gómez (2015) analyzes the impact of remuneration practices on banks' risk-taking, captured by the level of short-term leverage, in a model with fire sales externalities but exogenous effort and exogenous compensation contracts. Fire sales externalities are at the center of the new macroprudential approach to regulation [Kashyap et al. (2011)]. Fire sales occur when financially distressed firms need to sell assets at prices below their value in a best-use scenario. Fire sales can be quite sizeable and lead to high discounts relative to face value. For instance, in March 2012, Spain's Banco Santander sold property-backed loans for EUR 750 million at a 62 percent discount to face value. In June of the same year, the UK's Lloyds sold property-backed loans for EUR 971 million after a discount of 52 percent. Gete and Gómez (2015) show that when fire sales externalities are not internalized by a bank's shareholders and executives, borrowing is higher than the socially optimal level.
Regulating executive compensation can achieve socially superior outcomes because it alters the incentives of bank executives. They analyze four compensation structures proposed by the academic literature: 1 First, plain-vanilla equity fails to internalize fire sales externalities, as it does not "penalize" short-term relative to long-term payoffs.
2) and 3) Deferred equity and long-term bonuses unrelated to short-term profits can restore the efficiency loss induced by the fire sales externality. Long-term bonuses unrelated to short-term profits increase the opportunity cost of fire 5 Executive compensation as a policy tool to control leverage sales, thus, reducing fire sales. Deferred compensation works if agents value one dollar less in the future than in the present. If that is the case, then deferred compensation reduces the rewards from short-term debt. Thus, it lowers the incentives to leverage and sell at a discount in the case of a liquidity shock. Deferred compensation would be useless if it is invested in an interestmaking account paying the same interest rate as the bank executives' discount rate. In fact, deferred compensation can be thought of as a tax on compensation, where the tax rate is the executives' discount rate.
4) Bail-in bonds reduce incentives to short-term debt by paying equity in cases of bank distress, in which equity has no value. The advantage of bail-in bonds is that they are a "cheaper" way to provide incentives. They increase the opportunity cost of fire sales in periods with liquidity needs while avoiding any remuneration for executives in periods with no liquidity problems.
Compensation schemes in real life are actually more complex than in this model. They may include severance packages (which may increase the compensation's vega), trading restrictions (to limit the manager's ability to game the compensation incentives), or vesting periods for stock options. These mechanisms may help to curb CEO's risk appetite. Our numerical exercises, however, show that regulating the level of compensation can have unintended consequences. Setting upper or lower bounds on the number of shares, deferred shares and/or the size of long-term bonuses may lead bank executives to an overcautious choice of debt and, ultimately, fire sales below the socially optimal level.
Based on these insights, Gete and Gómez (2017) show that, when the CEO's choices of leverage and effort are endogenous, letting shareholders vote on the design of compensation schemes (like say-on-pay schemes) fails to prevent socially inefficient firms' overleverage.
Regulating the ratio of variable-to-fixed payments (but not the level of compensation) can deliver socially optimal leverage levels. Gete and Gómez (2017) conclude that, at least for risk-neutral agents, the optimal regulation is not the regulation of executive compensation. A cap on debt is socially more efficient: it can restore the efficient level of debt with a lower distortion in managerial effort. Whether this result holds after introducing managerial risk aversion remains open for future research.