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DP5818 CEO Power, Compensation and Governance

Author(s): Rui Albuquerque , Jianjun Miao
Publication Date: September 2006
Keyword(s): CEO power , moral hazard , CEO compensation , investor protection
JEL(s): G34 , J33 , K00
Programme Areas: Financial Economics
Link to this Page: www.cepr.org/pubs/dps/DP5818.asp.asp


This paper presents a contracting model of governance based on the premise that CEOs are the main promoters of governance change. CEOs use their power to extract higher pay or private benefits, and different governance structures are preferred by different CEOs as they favour one or the other type of compensation. The model explains why good countrywide investor protection breeds good firm governance and predicts a 'race to the top' in firm-governance quality after the Sarbanes-Oxley Act. However, such governance changes may be associated with higher rather than lower CEO pay as CEOs substitute away from private benefits. The model also provides an explanation for the observed correlation of CEO pay and firm governance based on CEO power. Finally, we discuss the optimality of introducing randomness in CEO hiring, for example, by evaluating CEOs based on qualitative characteristics, or soft skills, that are prone to diverse judgements.

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