The aftermath of the financial crisis of 2008 sparked an intense debate over executive compensation. A widely-held view among politicians, regulators, and the public is that CEOs extract high compensation through lax corporate governance practices, pointing to the need for strengthening corporate governance practices. A large empirical literature attempts to establish the causal effect of corporate governance on CEO pay, but the evidence is mixed. The mixed evidence is likely due to endogenous nature of both corporate governance and CEO pay as these variables are known to be correlated with many observable and unobservable industry, firm, CEO and board characteristics.
We make use of corporate governance reforms implemented in many countries around the world since early 2000’s and investigate their effects on CEO compensation. We focus on the CEO pay difference between public and private firms and investigate how a country’s exogenous corporate governance reform affects the difference in CEO compensations between public and private firms (ie pay premium). Utilising difference-in-differences technique with corporate governance reforms as exogenous events and private firms as benchmarks, our experiment provides an ideal setting to investigate the causal effect of governance strength on CEO pay.
Two prevailing views on executive compensation – rent extraction and efficient contracting – make opposite predictions on the relation between corporate governance reforms and pay premium. Rent extraction view posits that pay premium is due to agency problems. Thus, strengthening corporate governance should lead to a decrease in pay premium to the extent that governance reforms are effective in reducing agency problems of public firms by improving monitoring on CEOs. Efficient contracting view predicts that stricter corporate governance leads to increased monitoring on CEOs, which raises CEO efforts and the risk of dismissal, which in turn leads to greater pay demanded by CEOs for compensating their incremental efforts and risk.
We find that strengthening governance practices of public firms increases CEO pay significantly more for public firms than for private firms to which governance reforms do not apply. Public firm’s pay premium following governance reforms increases more for those public firms that are subject to higher scrutiny such as larger firms and firms followed by more analysts and firms whose shares are owned more by institutional investors. These results are consistent with efficient contracting view on CEO pay and inconsistent with rent extraction view.