Theories and Factors Explain the Growth in Executive Compensation Particularly In the Banking and Financial Sector
Introduction
The subject of executive compensation is a highly researched topic due to the many concerns revolving around strategic management finance law, accounting standards, labor economics, and industrial relations. Among the highly evaluated sectors on the subject is the financial and banking sector, where various theories have been postulated. Banking and financial institutions, which include brokerage firms, non-depository institutions, insurance firms, and commercial banks, have many similar attributes that make them almost homogenous despite differing in the services they offer. While these firms play an essential role in the economy, of concern, is how the executive is compensated. This is because the executive requires to be highly competent professionals whose desired qualities are essential in driving the financial institutions towards achieving their strategic goals. However, with fierce competition across the globe, the financial institution should attract and retain the best executive through proper compensation.
It is essential to assess the factors that influence executive compensation. The compensation should motivate the executive while ensuring that it is fair and guarantee equity among the shareholders. Basically, executive compensation takes comprises of three factors, the annual bones, basic salary, and stock-based plan (Perry & Zenner,2001). Proper implementation of these tools is likely to result in success through effectiveness and efficiency. The success of the financial and banking institutions is primarily assessed through profitability, along with other performance measures. This paper evaluates agency theory, stakeholder theory, equity theory, upper echelon’s theory, and social comparison theory, as the significant theories along with other factors that elaborate the growth in executive compensation in the financial and banking sector.
The Agency Theory
This theory explains the relationship between the financial institution and the executive (Denise, 2001). The executive compensation is influenced by the contract that exists between the executive and the institution since the former performs duties that affect the performance of the principal. In most financial institutions, the shareholders delegate the decision-making process to the board of directors (BOD), which further appoints the chief executive officer (CEO). The agency problem arises due to the impossibility of accounting for all actions taken by the executive, since they affect the welfare of the firm as well as that of the executive, as individuals.
Through the agency theory, compensation is influenced while addressing two main issues. First, the inability of the executive to perform with a high level of managerial integrity and competence. Secondly, making unwitting mistakes by the management during the execution of their responsibilities. Hence, these problems make it complicated for an institution to ascertain whether the executive is competent or whether it is willingly making mistakes that are adversely reducing a firm’s value by performing lower than expected.
While the institution and the executive aim at maximizing utility, there is a high probability for the latter to act in self-interest rather than that of the principal. To address that problem, financial institutions offer the executive some incentives to ensure it performs in the best interest of the employer. The incentives may include a good contract that is characterized by an excellent working environment and compensation. The incentives are essential in the reduction of agency problems resulting in the alignment of the management interests with those of the shareholders.
The Stakeholder Theory
This theory postulates that the executive should have a network along with the financial institutions to serve the employers, partners, and suppliers. Through the network, the interest of all the stakeholders can be addressed in a simple way rather than the principle-executive- employee relationship existing in the agency theory. The stakeholder theory focuses on the stakeholders’ that deserve the attention of the executive (Sundaram & INkpen, 2004).
The network of the relationships influences the decision-making process since all the shareholders aim to benefit from the operations of the financial institution. Therefore, a close assessment of the managerial decisions should reflect the interests of the shareholders who have intrinsic value. Hence, there are no stakeholders’ interests that should dominate others. The network created between the executive and the firm ensures that the interests of all parties are considered. Therefore, the executive makes optimal decisions in an environment where it feels it is not being shortchanged. Thus, compensation is one of the ways in which the executive remains motivated in meeting the needs of all stakeholders. In case the executive is poorly compensated, it will take actions founded on self-interest.
Equity Theory
This theory postulates that the executive makes a subjective assessment based on their input and compensation ratio and compares them to others. That means the equity theory takes into consideration equity in the input and output of the executive. In case the ratio is unfavorable, the executive can resign. Hence, dissonance resulting from an imbalance in the ration can result in an executive turnover. Further, the imbalance can result in reducing input or efforts being made by the executive. Notably, the imbalance may be justified in some situations compared to the compensation of others in the same industry.
According to Moore and Small (2007), social psychologists have proven than in many cases, people tend to overestimate their potential relative to that of others, a situation referred to as a self-enhancement. Self-enhancement happens to be ambiguous when considering the executive contribution and the overall performance of a firm. Self- enhancement among the executives hinders the application of equity theory during executive compensation. Nonetheless, the equity theory concurs with labor economics theory contribution that demands those making greater contributions to be compensated more. While the employees contribute to the success of the financial institutions, the CEOs demand more compensation because of the management decisions they make in realizing success.
Social Comparison Theory
The social comparison theory revolves around the executives’ character comparing themselves with others in the same position, ability, and demographic characteristics (Gartenberg & Wulf, 2017). The top executive in the financial and banking sector have many similarities and differentiate themselves by referring to the others. The comparison revolves around status-driven, achievement-oriented, motivation, and power-seeking. More so, the executives also go through similar vetting, promotion, and selection processes. Therefore, their performance is likely to be influenced by the outcome of the comparison. The motivation of the executive is a product of both monetary and non-monetary incentives. Therefore, in the financial and banking sector, the executive in a successful firm demands compensation for better than competing institutions, without which their performance will decline or be reassigned.
Upper Echelon’s Theory
The upper echelon’s theory postulates that the top management’s top decisions are influenced by demographic characteristics that eventually affect an organization’s performance. According to Goll, Sambharya, and Tucci (2001), the corporate ideology needs to link the firm’s performance and that of the executive. The executive performance influences the overall performance of a firm through the creation of a cognitive base in the decision-making process, which limits their vision. The executive characteristics such as education, marital status, religion, and age can either inhibit or promote an organization’s performance. Hence, the theory inquires how executive remuneration, along with other incentives, affects a firm’s performance.
Other Factors
The other factors that influence executive compensation include the performance of the firm. Pay-performance is common in the financial and banking sector and other sectors of the economy. There are many firms where the incentives and compensation are founded on the financial performance of a firm. Therefore, the executive makes decisions that will result in achieving the expected results of the financial institution. The executive earns bonus when positive outcomes are realized. The incentives could be through bonus plans and executive share option plans. When compared to those of other sectors, the incentives could motivate to inhibit executive performance.
Conclusion
The financial and banking sector is essential in the economy since it influences how money flows in an economy. The executive team mainly influences the performance of this sector. Compensation is one of the factors that affect the performance of the executive, which is further reflected by the financial institution’s performance. Some of the theories explaining the growth of executive compensation include the agency theory, the upper echelon’s theory, and the stakeholder theory. Other factors include the performance of a financial institution. These factors and theories justify increasing executive compensation in the banking and financial sector.
References
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