Monday, October 06, 2008

Capping CEO Pay - why Golden Parachutes save firms money.

There's been a lot of talk about capping CEO pay--which is included in the last bailout bill--and pretty much all of it has been ideological; no one has asked an economist what it all means.

So yes, from an "optics" view as they say in Washington, paying CEO's huge bonuses when they are forced to leave a failing company looks awful.

But from an economic point of view, the point of Golden Parachutes is to transfer risk from the risk averse potential CEO to the risk neutral firm. It is not something you give to reward a CEO for leaving, it is something to promise at the beginning to get him to join. What basic contract theory says is that by reducing the risk to the CEO for taking the job, you actually have to pay him/her less overall. Thus a ban on Golden Parachutes should lead to increased overall CEO compensation.

Of course a more likely and better outcome is that if a ban is in place, companies will come up with contracts to replicate golden parachutes, but don't look like golden parachutes. Perhaps a loan that is paid out of future wages. (Which I guess is already done and still looks bad, but less bad.)

No comments: