Cash Salary, Inside Equity, or Inside Debt?—The Determinants and Optimal Value of Compensation Structure in a Long-term Incentive Model of Banks

Tianyi Ma,Xuchuan Yuan,Minghui Jiang

doi:10.3390/su12020666

Tianyi Ma, Xuchuan Yuan + Show 1 more

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https://doi.org/10.3390/su12020666

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Abstract

The design and optimization of executive compensation structure to reduce the risk-taking of banks is one of the core topics of corporate governance theory. Especially after the 2008 global financial crisis, due to the characteristics of banks, such as systemic risk, this issue has become more important. However, though widely concerned, the determinants and design principles of compensation are not thoroughly understood. Based on our previous work, the setup of a banker’s long-term total compensation model, we continue our research by setting up a theoretical model between total compensation, bank default risk, and the structure coefficient by simulating the result using data from Wells Fargo and Co. to draw the function image. We are the first to find out the determinants of structure, that is, the working time, current age, and tenure. What is more important is that we find that increasing the weight inside debt in the total compensation is not only helpful for the reduction of the bank’s default risk, but also an increase of the banker’s total compensation. We also illustrate the influence of a number of periods. We expect our findings to offer help regarding the formulation of policies for pay contracts.

Highlights

In 1976, Jensen and Meckling [1] first published their article about executive compensation
We demonstrated the relationship of the structure coefficient of total compensation with the bank’s default risk by formulating a particular formula
We are the first to find out the determinants of structure, that is, the working time, current age, and tenure

Summary

Introduction

In 1976, Jensen and Meckling [1] first published their article about executive compensation. Since elucidating how to design the pay contract and optimize the structure of banker’s compensation is becoming more and more prevalent in corporate governance theory. We define the total compensation as the sum of cash salary, inside equity, and inside debt. The structure coefficient in our paper stands for the weight of inside debt in total compensation, where “inside equity” is the equity-based compensation paid in the form of restricted stock, stock options, and other instruments, of which the value lies in the equity returns in the future. Per Jensen and Meckling [1], “inside debt” is defined as benefit pensions and deferred compensation. The object of our research is to find out the optimal level of the structure coefficient to decreased the bank’s default risk and to increase the banker’s total compensation

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