A recent empirical literature shows that competition among ?rms tends to increase the performance-pay sensitivity of compensation schemes (Burges and Metcalfe 2000, Cu?at and Guadalupe 2004, 2008 and 2009, Guadalupe 2007 and Karuna 2004). In this paper, I offer an explanation for this empirical regularity.
Managerial compensation, and their year to year change in wealth, varies significantly with the excess return on their firms stock. The positive correlation is primarily driven by the fact that managers hold stocks and options in their own firms. A large body of nonstructural empirical work has investigated how well managerial compensation can be rationalized by moral hazard.
As the dominant paradigm for explaining executive compensation, the theory of moral hazard postulates that risk averse managers are paid compensation that fluctuates with signals shareholders observe about decisions their managers make, notably excess returns of the firm, in order to align the incentives of the managers when their non pecuniary goals differ from maximizing shareholder wealth and the actions and decision of management are not monitored by shareholders. A growing number of papers on structural estimation have sort to quantify the economic significance of moral hazard in the labor market.
Cross-border activity in the banking industry remains relatively low in the European Union (ECB, 2007). This trend is considered as problematic by European authorities as cross-border activity is viewed as a necessary condition for the implementation of the Single banking market and therefore as a positive factor for the enhancement of competition and cost performance in the European Union. This view is notably illustrated by the European Central Bank in their description of the state of financial integration in Europe: “Cross-border banks play an important role in the process of banking integration. They enhance competition in the euro area banking markets (…). In this fashion, they promote convergence towards more efficient, lower-cost banking practices.” (ECB, 2007, p.33)
