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December 1, 2021

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High CEO pay can encourage wider wrongdoing

Research suggests that CEO stock option schemes combined with a large pay gap can encourage and motivate lower-ranking employees to commit illegal behavior.

Previous research had considered how pay schemes that link compensation to stock market performance, particularly in the form of option pay, can encourage a CEO to take risks that might result in wrongful behavior. Likewise, in companies with particularly large pay gaps between the CEO and the rest of the top management team, disgruntled executives who perceive the pay policies to be unfair may be more motivated to steal from the organization. However, no research had asked the question: Can CEO pay drive other employees in the firm, not receiving the pay, to commit wrongdoing?

Using a sample of US Bank Holding Companies (BHCs) from 2007 to 2013, we examined whether there was a link between CEO option pay and the pay gap with the probability of individuals in the wider workforce committing wrongdoing.

Publicly traded BHCs provided an excellent research context for several reasons. First, they use high amounts of incentive pay and are required to disclose compensation data, making it possible to compare CEO pay to the average pay in the organization. Second, the regulatory requirements and risk management schemes in the banking industry make it easier to detect incidents of wrongdoing. Indeed, between 2007 and 2013, more than 2,000 individuals were banned from working at a US bank by regulators due to alleged wrongdoing, such as embezzling funds, forging documents, or accepting bribes. Third, banks’ central role in the functioning of the economy, as shown by the 2008 financial crash, makes the study of wrongdoing in this industry particularly relevant.

The researchers found strong evidence that both CEO option pay, and the pay gap between the CEO and average employees, increased the likelihood of wrongdoing. Indeed, this effect was quite large. In banks with no CEO option pay plus a low pay gap, there was only a 5 percent probability of wrongdoing, compared with firms with high CEO option pay and a high pay gap where the probability of wrongdoing leapt to 33 percent — an almost sevenfold increase.

Social inequality

This research is particularly relevant, because in recent years the gap in pay has risen along with societal inequality, stoking concerns of greater social and economic instability.

In fact, CEO pay at the largest US firms has grown to 299 times that of the average worker, while at the same time, incidents of fraud and wrongdoing at companies have increased.

Given this backdrop, what steps can companies take to limit wrongdoing?

CEOs and top executives have major influence over the culture in their organizations.

They can set the tone for the entire organization by, for example, how they punish incidents of wrongdoing in the firm, and how they set pay schemes for lower-level employees.

However, interviews with top executives in banks exposed divergent views about how much the buck stopped with them in terms of preventing wrongdoing.

In interviews, some top executives in banks took personal responsibility for preventing wrongdoing.

Others literally shrugged their shoulders when asked what they can do to make their organization behave more ethically.

It is not surprising that there were such divergent outcomes in terms of wrongdoing when top managers’ attitudes on personal responsibility also differed so much.

Previous research shows that the incidence of wrongdoing declines significantly when the probability of detecting it and the severity of punishment is high.

Potential wrongdoers are more likely to be deterred if they know they face negative consequences if caught. This sounds like common sense. However, some companies have different rules for executives than for the rest of the firm. This double standard is always noticed, and it can fuel resentment.

When boards of directors are designing pay packages for CEOs, they need to consider the effect on other stakeholders, such as employees. Elevated levels of option pay can incentivize risky behavior and divert attention away from risk management, providing greater opportunities for others to commit wrongdoing. Moreover, while big pay packages for the CEO and other top executives can act as a carrot to motivate people to work hard and climb the corporate ladder, they can also induce feelings of envy and resentment. This can make employees slack off, have lower job satisfaction, cooperate less with colleagues, and even quit their jobs more frequently.

Stephen (Steve) Smulowitz is a Term Research Professor at the IMD Global Board Center. Juan Almandoz is a Professor in the Department of Managing People in Organizations at IESE business school.


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