Li, J., J. Yang, and Z. Zou

Publication:

Journal of Banking and Finance

Abstract:

We investigate an alternative economic channel of a positive relationship between risk and compensation, as documented by Cheng et al. (2015). We propose that when information asymmetry exists, firmsgenerally seek to use compensation as a signal of their CEOs’ ability. The risks arising from informationasymmetry tend to encourage firms to pay higher compensation to their CEOs in a pattern of financialincentives we call the “Lake Wobegon effect”. However, when individual firms pursue complete signaling,a higher equilibrium compensation level can be achieved. This paper explores the factors that give riseto the “Lake Wobegon effect” and the learning process by which this effect can be counterbalanced overtime (Hayes and Schaefer, 2009).

[Keywords] Compensation; Risk; Asymmetric Information; Learning; Belief