Master Thesis

Master Thesis

Does CEO compensation affect corporate risk-taking? A

closer look at the technology industry

By

Yibo Wang

Supervisor: Dr. H. Gonenc

Co-Assessor: Dr. W. Westerman

Submitted for the degree of

MSc International Financial Management

Double Degree with Uppsala University

Faculty of Economics and Business

Rijksuniversiteit Groningen

Uppsala Universitet

y.wang.79@student.rug.nl

Abstract

This thesis examines the effect of executives compensation on corporate risk-taking using

19,026 firm-year observations over the period of 2004 to 2015. The study especially

emphasizes the characteristics of the technology industry and its inherently high levels of

uncertainty. The individual level of corporate governance is developed as a firm-level

moderator, and levels of investor protection, uncertainty avoidance and individualism as

country-level moderators for corporate governance and cultural dimensions. It is concluded

that there is a positive relationship between executive compensation and risk-taking and

investor protection positively moderates this relation. Besides, uncertainty avoidance negatively moderates the relation between compensation and risk-taking. Both effects are

found to be stronger in the technology sector. I find country-level variables but not firm-level

variables to be determinants of the compensation-risk relationship.

Abstract 1

1. Introduction 3

2. Literature review and hypotheses development 8

2.1 Literature review 8

2.1.1 CEO compensation and agency theory 10

2.1.2 CEO compensation in technological sector 12

2.2 Hypotheses development 14

2.2.1 Relationship between CEO compensation and corporate risk-taking 14 2.2.2 Firm-level Governance as a moderator of the Compensation-Risk relationship 16 2.2.3 Country-level Governance as a moderator of the Compensation-Risk relationship 20 2.2.4 Cultural Dimensions as moderators of the Compensation-Risk relationship 23

Figure 1. Conceptual model 26

3. Methodology, Data and Sample 26

3.1 Methodology 26

3.1.1 Dependent variable 26

3.1.2 Independent variable 27

3.1.3 Firm-level corporate governance variables 28

3.1.4 Country-level variables 28

3.1.5 Control variables 29

3.1.6 Regression models 30

3.2 Data and sample 32

4. Results 33

4.1 Descriptive statistic and correlations 33

4.1.1 Descriptive statistics 34

4.1.2 Correlations and multicollinearity 37

4.2 Regression results 38

5. Conclusion 45

Acknowledgement 49

1. Introduction

Not least because of the financial crisis in 2008 and the still perceptible consequences up to

this point, corporate risk-taking is in the focus of public attention. Excessive corporate

risk-taking was said to be one of the key triggers for the last financial crisis that expanded to a

whole economic crisis. A balanced level of corporate risk-taking is therefore not only crucial

for the success of each individual firm, but also for the stability of the economy as a whole.

The excessive levels of risk that are against laws and regulations, executives can also damage

their firms with excessive levels of risk-taking within the boundaries of law. The levels of

risk-taking are a key determinant of firms successes or failures and therefore present a very

interesting field of study. Especially the technology sector is characterized by enormously

high levels of uncertainty in the market. The pace of technological change has been growing

for years in is expected to continue to grow at an even higher pace. In this highly risky

environment one might wonder how firms and shareholders in particular manage to keep the

level of risk in their corporates’ decision-making procedures within acceptable boundaries.

Not only high risks can lead to firm failure, but also too low levels of risk-taking can harm a

firm’s financial success because the firm misses out the technological developments of the

future.

The former CEO of Ford in the 1960s, Lee Iacocca, made this famous statement about risk in

the technology sector:

“The greatest hindrance of business success in our industry is managerial overthinking. At some point, you just need to embark on a journey to the unknown. The best decision can be

wrong if it takes too long.” (Lee Iacocca, 1972)

One tool for shareholders to direct executive risk-taking is executive remuneration. The

design of compensation packages is an effective tool to overcome managers’ individual risk

tendencies and direct their level of risk towards the shareholders’ expectations. The balance

between fixed pay elements and incentive pay elements is crucial in this respect. This paper

aims to contribute to the existing body of literature as it develops hypotheses about

and thereby takes a closer look at the technology sector. I will now shortly review relevant literature and derive my research question.

Numerous studies have been done about the relationship between CEO compensation and

organizational performance (Murphy, 1985; Kren & Kerr, 1997; Carpenter et al., 2003; Brick

et al., 2006; Firth et al., 2006; Kwon & Yin, 2006; Makri et al., 2006; Lin et al., 2011; Banker

et al., 2012). Most of the researchers suggest that there is a positive relation between these

two variables (Murphy, 1985; Carpenter et al., 2003; Brick et al., 2006; Firth et al., 2006;

Banker et al., 2012), some however also find a negative relationship. Banker et al. (2012) find

a negative relation between future Return on Equity (ROE) and executives bonus. No direct

association between pay and financial performance is found by Kren & Kerr (1997).

Given that CEO pay and performance are mostly considered to positively correlated, CEOs

will be inspired to make risky decisions and take higher levels of risk when they receive more

compensation, leading to a better performance. Therefore, higher levels of CEO

compensation will motivate CEOs to take higher risk, indicating that corporate risk taking is

positively affected by CEO compensation. The importance of executives compensation

packages has attracted much attention lately and it has developed into a part of corporate

governance policy.

Many researchers have examined the relationship between executives compensation and

corporate risk-taking (Aggarwal & Samwick, 1998; Carpenter et al., 2003; Dee et al., 2005;

Brick et al., 2006; Coles et al., 2006; Fernandes et al., 2011). Prendergast (2000) finds that

there is a positive relationship between executives incentive compensation and uncertainty.

Additionally, Dee et al. (2005) state that firms ought to make tradeoff decisions between

executives compensation and corporate risk-taking, as managers will request higher pay for

the greater risk they bear, especially in a dynamic fast-changing environment, such as the

technology sector. Jensen and Meckling (1976) restate agency theory in a way that managers

will make an effort to enhance their private wealth and interest, in order to ensure personal

income and the stability of their job. Coles et al. (2006) maintain that there is a propensity that

managers need to decide from different investments, which will consequently harm shareholder value.

Technology has been playing a critical role in the growth and development of the society and

economy in the 21st century (Makri, et al, 2006). The rapid growth in technology improved

social development to a great extent, and innovation in production and advancement in

production methods play a significant role in economic development (Barney, 1991; Balkin et

al, 2000). Rogers (2001) shows that the number of high-tech firms is booming since

technology has been a driving factor for social sustainable development, and the large number

of emerging high-tech firms is one of the primary driving forces in modern economic growth.

In addition, huge changes in competitive markets provides enormous space for the

improvement of innovation and creativity (Rogers, 2001). Ryan et al. (2002) state that

executives compensation packages are different from those of other industry since there is

higher R&D intensity in technological industry. R&D projects are highly risky themselves, so

firms need to establish different managers compensation structures and higher level of pay to

encourage decision makers to invest in those projects even though they are risky (Rogers,

2001).

A large number of studies have been done about the relationship between executives

compensation and corporate risk-taking, but not many of them focus on technological firms.

Therefore, it is interesting to study the relationship between executives compensation and

risk-taking in technological industry. This thesis contributes to the existing research by

studying the compensation-risk relationship in technological industry.

Besides, firm-level corporate governance characteristics have an effect on the correlation

between executives compensation and corporate risk-taking as well according to previous

study (Jain et al., 2014; John et al., 2008). A higher level of corporate governance can fixate

corporate executive’s remuneration at a level where it is best in order to serve shareholder’s

interest and prevent or at least minimize the extraction of private benefits by corporate

executives. If firms have high levels of corporate governance, they can more efficiently

overcome their internal agency problems and therefore display better performance measures

their monitoring capabilities with higher degree of corporate governance and will reach a more efficient level of risk-taking and higher quality of corporate performance, which

suggests the influence of corporate governance on compensation-risk relationship. Therefore,

it is also interesting to research the effect of firm-level corporate governance characteristics on

compensation-risk relationship in this study.

Further, some country-level characteristics like investor protection also have an impact on

executives compensation and corporate risk-taking besides firm-level corporate governance

characteristics and industry characteristics. According to Zheng et al. (2016), it is suggested

that there is a positive relationship between investor protection and executives compensation.

In countries with stronger investor protection, agents will be less encouraged to act in their

own private interests and have more motivation to generate more profits for shareholders

(Zheng et al., 2016). John et al. (2008) point out that the alignment of interests between

shareholders and managers can be accomplished with better investor protection, leading

managers to bear higher risk. On the other hand, stakeholders will have bigger influence on

companies when firms locate in countries with poor investor protection. Agents will

undertake lower level of corporate risk as a result of the pressure from these stakeholders

(John et al, 2008). Stronger investor protection will encourage managers to bear greater risk,

and invest in riskier projects with higher profits (Houston et al., 2010).

Moreover, previous studies show that national culture also has an effect on management control systems and corporate governance practices, such as executives compensation

structure (e.g. Hofstede et al., 1991; Chow et al., 1999; Van der Stede, 2003; Jansen et al.,

2009). Jansen et al. (2009) indicate that uncertainty avoidance and individualism as cultural

dimensions have the most critical influence on the design of executives compensation packages.

Considering these firm and country-level moderators of the compensation-risk relationship

and the the special characteristics of the technology sector, the research question of this thesis

How do firm and country-level characteristics affect the relationship between CEO compensation and risk-taking? Does the higher level of uncertainty cause these effects to be different in the technology sector?

Over a sample period from 2004 to 2015, I construct a dataset of 19,026 firm-year

observations and conduct statistical analysis to answer the posed question. I subdivide my

sample into a technology and non-technology cluster to highlight the special characteristics of

the technology sector. I find country-level variables to be significant determinants of the

compensation-risk relationship opposed to firm-level variables that don’t have an effect.

Investor protection positively moderates the relationship, whereas uncertainty avoidance

moderates it negatively. Both effects are found to be stronger in the technology sector due to

its high level of inherent uncertainty and higher required levels of corporate risk-taking.

The rest of the thesis is structured as follows. Section 2 provides a brief review and discussion

about previous research over the relationship between executives compensation and corporate

risk-taking, and hypotheses development. Section 3 presents data collection and regression

models. This thesis uses Linear regression method to test the hypotheses developed in section

2. Literature review and hypotheses development

The following section will proceed as follows: First, I will summarize the relationship

between CEO compensation and corporate risk-taking from previous literature. In a next step,

I will highlight the specific characteristics of the technology sector and their effect on the

relationship of CEO remuneration and corporate risk-taking. I will then proceed to the

development of my hypothesis.

2.1 Literature review

Numerous studies have been conducted in order to discuss the impact of executive

remuneration on organizational performance and risk-taking (e.g. Aggarwal & Samwick,

1998; Cui & Mak, 2002; Carpenter et al., 2003; Dee et al., 2005; Brick et al., 2006; Coles et

al., 2006; Finkelstein et al., 2009; Fernandes et al., 2011). Aggarwal and Samwick (1998)

indicate that there is a positive relationship between executives incentive compensation and

risk-taking. Coles et al. (2012) show, that CEOs should get convex compensation to reduce

the propensity that risk-averse managers avoid risky investments. They emphasize the importance of CEO motivation through specific incentive structures. These incentive

structures mainly refer to a heightened use of performance-based compensation components

(e.g. bonuses) compared to fixed compensation components (e.g. base salary). Scholars further conclude, that pay-performance sensitivity is negatively associated with risk

(Aggarwal & Samwick, 1998; Jin, 2002; Dee et al., 2005). Therefore, performance-based pay

is positively evaluated by many scholars in order to induce managers to make right investment

decisions and choose positive Net Present Value projects and consequently create more value

(Prendergast, 2000; Dee et al., 2005; Coles et al., 2006). The study of Ayadi et al. (2012)

further suggests, that the implementation of equity-based compensation will encourage

managers to take more risk. It can therefore be concluded, that risk-taking is positively related

to the use of long-term incentives. Ayadi et al. (2012) highlights the crucial importance of

CEO compensation structures for the economy as a whole by referring to the development and

evolution of the financial crisis in 2008. Excessive corporate risk-taking gave rise to the credit

crisis because CEOs were encouraged to take extremely high risks to get high bonuses in the

financial sector (Ayadi et al., 2012). Despite a broad consensus in the literature, some scholars

states, that managers will make an effort to improve the diversification of the portfolio they

have in order to decrease the risk of the portfolio in a performance-based compensation

environment. He argues that this could be bad news for investors due to the negative effect of

insider sale, and consequently harm firm value because investors will demand compensation

for this negative effect. It is therefore critical for firms to establish an appropriate

compensation system and keep a balance between CEOs’ fixed salary and variable pay. This

will motivate decision-makers not to neglect risky but profitable projects, but still control risk

within safe levels (Dee et al., 2005).

Many studies suggest high cross-country differences amongst CEO compensation. Academics

observe the fact, that on average US firms pay a lot more to their CEOs than other countries.

Especially in the banking industry, which even lead to the bankruptcy of investment banks

during the financial crisis in 2008, as this kind of compensation practice incentivised

corporate executives to focus mainly on short-term benefits instead of long-term objectives

(Friedman & Friedman, 2009; Adams, 2012). However, Fernandes et al (2012) claim that

American CEOs compensation is appropriate, after controlling for firm size, industry, country

characteristics, board structure and ownership, and that US CEO compensation structures just

comply with the requirements of the board and shareholders about performance-based pay.

The compensation structure differs amongst the portions of fixed and performance-based pay

and the total level of CEO compensation amongst countries, characteristic for the US is a high

level of performance based bay and a high total compensation. Germany and its very high

proportion of fixed pay components and a comparably low level of total compensation

presents a sharp difference to that.

According to Fernandes et al (2012), not only industry, firm size and leverage have an effect

on the CEO compensation structure, but also country characteristics, institutional ownership and corporate governance practices will affect CEO remuneration. Similarly, Bertrand and

Mullainathan (2003) find, that a higher proportion of institutional shareholders implies a

higher pressure on management activities, this requires higher managerial abilities to cope

with these expectations and subsequently a closer relationship between CEOs compensation

and organizational performance can be observed. Fernandes et al (2012) further note, that

firms have a higher proportion of institutional shareholders. It can be further observed that

shareholders will use the corporate executives compensation structure as a tool in order to

push their preferred risk-profile in the firm’s actions. In contrast to economic intuitions, CEO

pay will be higher with better supervising and monitoring of shareholders and a higher

firm-level corporate governance (Fernandes, et al, 2012). Risk-profiles of shareholders and

firm’s levels of corporate governance are shown to substantially differ amongst countries,

further highlighting the importance of cross-country variables when analyzing CEO compensation structures. Furthermore, these characteristics even differ amongst industries and

require a consideration of industry-level characteristics as well. The technology sector and its

characteristically dynamic and therefore also risky environment are an interesting object of

study in this context since the riskier nature of business is likely to have an effect on the

discussed relationship between CEO remuneration and corporate risk-taking. Corporate

executives in the technology sector are likely to get a high proportion of variable

compensation components in order to motivate them to invest in risky projects with higher

expected returns and subsequently create more shareholder value (Kwon & Yin, 2006;

Yanadori & Marler, 2006). The next section will outline the implications of agency theory on

the effect of compensation structures on corporate risk-taking in order to understand the

general relationship in more detail.

2.1.1 CEO compensation and agency theory

According to previous research, financial incentives can induce CEOs to manage and control

firms with responsibility, so managers are paid bonuses or other forms of rewards besides

their base salary in order to be motivated (Jansen et al., 2009). As mentioned, fixed pay and

performance-based pay are the two main types of executives compensation. Reference to

Hillier et al. (2012) reveals that performance-based pay can be divided into equity-based

compensation, such as restricted stocks and stock options, so-called long-term incentives and

earnings-based compensation, for example bonuses based on net profits or cash flow,

so-called short-term incentives. These two types of performance-based pay have their own

advantages and disadvantages. In terms of equity-based compensation, it encourages agents to

promote stock price, which is in line with shareholders’ expectations but makes stock prices

highly volatile on a daily basis (Hillier et al., 2012). Elaborating on earnings-based

likely to obtain this kind of compensation (e.g. bonus on net profit), but also corporate

executives from private companies can get it since it’s not based on publicly-traded stock

prices. But according to the work of Hillier et al. (2012), the values of financial indicators,

such as net profit or cash flow, could be manipulated by changing accounting policies or

applying other manipulation techniques to improve managers’ financial rewards.

Earning-based compensation therefore offers corporate executives opportunities to commit

financial information fraud. These opportunities were exploited by executives and resulted in

large scandals, such as Worldcom and Arthur Anderson. Legislative bodies tried to prevent

earning manipulation through the Sarbanes-Oxley act in a response to these scandals

(Rockness & Rockness, 2005). Since the occurrence of earning manipulations and thereby the

destruction of shareholder value however happened time and again, firms now largely abandoned earnings-based pay structures. The mentioned scandals highlight the crucial

importance of corporate remuneration structures for the firm’s risk-taking through agency

conflict.

The work of Jensen and Meckling (1976) indicates, that the separation of management and

ownership will cause a conflict of interests between managers and shareholders. The

separation causes information asymmetries between managers and owners, as well as

managers’ efforts to extract their own benefits from firm resources. According to agency

theory, managers will try hard to maximize their own wealth and interest, to guarantee

personal income and the stability of their job (Jensen & Meckling, 1976). In addition, the

work of Jensen and Meckling (1976) indicates that the separation of management and

ownership gives rise to a firm’s competitive advantages as well as agency problems. These

agency issues are opposed to organizational objectives of shareholders value maximization

and carry the possibility of opportunistic management behaviour. Rogers (2001) argues, that

in order to decrease managers’ opportunistic behaviour, firms need to establish efficient

corporate governance practices and effective monitoring mechanisms to force managers to act

in the firm’s collective interest. Moreover, Jensen and Murphy (1990) emphasize the

importance of executive compensation structures to overcome these agency issues. The design

of executive compensation is supposed to create incentives and motivation for

decision-makers to increase firm value and most importantly act in line with the shareholder

risky projects, leading to managers’ risk-aversion, which means decision-makers tend to

choose less risky projects with lower expected returns, instead of risky projects with higher

expected returns projects when faced with different options. This managerial risk-aversion is a

form of agency problem which has negative influence on shareholder value. Ryan et al.

(2002) conclude, that the primary function of equity-based compensation is to give managers

motivation to act in shareholders’ benefits by raising corporate risk-taking. Therefore the

mitigation and elimination of the agency problem brought by risk-averse managers is

especially important to firms’ sustainable development and long-term objectives and firms

can individually choose specific compensation structures to overcome this problem. (Coles et

al., 2006). Jensen and Meckling (1976) show, that shareholders will search for and implement

certain types of compensation structure to align the interests of managers and owners,

encouraging managers to take higher risk and subsequently create more shareholders value

and decreasing the possibility of managers’ opportunistic behaviour. Rajgopal and Shevlin

(2002) show, that the conflict of interests between managers and owners could even increase

if managers are offered too much equity-based compensation components.

I conclude, that CEO compensation structures are a crucial determinant of corporate

risk-taking. This relationship is affected by cross-country and cross-industry variables, I will

now further elaborate on the individual industry sector and the sector characteristics as a

cross-industry variable. Since the technology sector is widely considered the most dynamic

and uncertain sector in the economy and therefore imposes a high level of risk simply by the

nature of the sector, this sector is especially interesting to look at.

2.1.2 CEO compensation in technological sector

Makri et al. (2006) argue that technology has been playing an important role in social

development these years. The fast improvement in science and technology promoted the

development of human society, in the meantime innovation in production technology and

changes in production methods play a critical role in economic development (Barney, 1991;

Balkin et al, 2000). The work of Rogers (2001) reveals that the number of high-tech firms is

booming due to technology being the main driving factor for sustainable development. The

rapid emergence and growth of high-tech firms is one of the primary driving forces of social

space for the improvement of innovation and creativity (Rogers, 2001). The fact that

innovative technology and achievements are exploited in high-tech firms in order to improve

the efficiency of production and management through services or products, has been one of

highlights in the new era of economic growth in the 21st century (Rogers, 2001). Firms in the

technological sector are characterized by a high quantity and ideally also quality of R&D

investments, plenty of intangible property, such as patents, employees with high education,

and strong creative capabilities. (Kwon & Yin, 2006). The growth of high-tech firms is

therefore the inevitable outcome of sustainable development of innovation and technology.

Scholars show, that corporate executives prefer incentive pay, such as stock options compared

to fixed salary items in high-tech firms, a very risky and fast-changing environment

(Prendergast, 2000). The work of Dee et al. (2005) argues, that firms need to make tradeoff

decisions between executives remuneration and risk, as managers will request higher pay for

the greater risk they bear, especially in the highly developing and highly volatile industries,

such as high-tech firms. Furthermore, there are substantial differences in CEO compensation

practices between high-tech and low-tech firms according to the study of Kwon and Yin

(2006). They state, that corporate executives get higher total compensation in high-tech firms

compared to low-tech firms. High-tech firms provide managers with higher proportions of

equity-based compensation, such as stock options, yet their base salary or cash rewards are

not necessarily higher than those of managers in low-tech firms (Kwon & Yin, 2006). The

authors provide different explanations to explain these differences amongst the

technology-level of a firm. One explanation is, that high-tech firms need to spend more

money on R&D projects to maintain their innovative capabilities in the

dynamic-technological market, which means managers bear higher risk in high-tech firms

than in low-tech firms. The naturally high level of uncertainty is one of the key attributes of

R&D investments, which make them more difficult to monitor and assess (Kwon & Yin,

2006). Thus, those high-tech firms are more willing to provide CEOs higher pay to undertake

greater level of risk (Cui & Mak, 2002). At the same time, CEOs will request for higher pay

to compensate the higher risk they undertake in high-tech firms (Cui & Mak, 2002). Kwon

and Yin (2006) further argue, that the nature of business in the technology sector and the

induced level of uncertainty make it very hard for shareholders to efficiently monitor and

create a stronger bond between shareholder motives and the motives of the individual

executive. If high-tech firms use high levels of earnings-based compensation, such as bonuses

basing on total cash flow, it will discourage managers to invest in positive-NPV projects with

high risk (Kwon & Yin, 2006). The implementation of stock options as incentive

compensation is more common in technological firms in order to motivate managers to act in

shareholders’ interests and align the interests of stockholders and corporate executives as their

investment decisions will have an effect on their private benefits through stock prices (Rogers,

2001).

It can be concluded, that due to the fast-changing and risky environment, CEO compensation

structures are different in technological firms compared to those in other industries. (e.g. Coy,

2000; Nesheim, 2000; Rogers, 2001; Cui & Mak, 2002; Carpenter et al., 2003; Dee et al.,

2005; Kwon & Yin, 2006; Makri et al., 2006; Yanadori & Marler, 2006; Lin et al., 2011).

Managers have to undertake higher risks in the technological industry caused by the high level

of uncertainty in the sector, shareholders will consequently provide more incentive

compensation elements to corporate executives to make up for the higher risk they bear. All

these studies suggest a stronger relationship of CEO compensation (as a measure for good

corporate governance) and corporate risk taking.

2.2 Hypotheses development

2.2.1 Relationship between CEO compensation and corporate risk-taking

As Coles et al. (2006) have indicated, executive compensation systems have a significant

impact on corporate risk taking and risk-taking is positively related to the sensitivity of

executives compensation to the volatility of the firm stock price. For example, riskier

practices like higher R&D spending, lower investment in tangible assets or more debt (higher

leverage) are more likely to be implemented in the organization if the corporate remuneration

packages are efficient in optimizing corporate risk-taking. Coles et al. (2006) further state,

that CEOs should get convex compensation to reduce the propensity that risk-averse managers

avoid risky investments. These convex compensation packages imply an increasing degree of

CEO compensation participation in firm success with increasing profits. This will increase

their motivation and incentives to bear risks (Coles et al., 2006). The higher coupling of CEO

to increase their risk-tolerance in order to maximize their own remuneration. The work of Dee et al. (2005) argues, that firms need to make tradeoff decisions between executive

remuneration and risk, as managers will request higher pay for the greater risk they bear.

Previous studies emphasize, that pay-performance sensitivity is negatively associated with

risk (e.g. Aggarwal & Samwick, 1998; Jin, 2002; Dee et al., 2005). The work of Ryan et al.

(2002) suggests that there is a negative relationship between the use of equity-based

compensation (such as stock options) and leverage, which could be a proxy for risk-taking.

This implies, that not all elements of CEO compensation are suitable in the generation of

incentives for executives to increase their risk-taking practices. In the financial crisis, one of

the main driving forces of the excessive risk-taking in the economy were flawed and

enormously high CEO compensation packages who encourages executives to take too much

risk. This recent evidence however supports the hypothesis of a positive relationship of CEO

compensation and corporate risk-taking as this effect could be observed in the economy. Dee

et al. (2005) consequently find, that equity-based compensations will induce managers’

risk-taking behaviour. The financial crisis proves this assumption in a drastic manner, as the

positive relationship between corporate compensation and corporate risk-taking seems to be

characterized by exponential or at best linear growth.

All these studies suggest a positive relationship between CEO compensation and corporate

risk-taking because CEO compensation packages can overcome the initial risk-averse

tendencies in corporate executive’s decision-making processes. This hypothesis is further

supported by the aforementioned aspects in agency-theory, incentive-alignment theory and

managerial power theory.

As mentioned in the literature review, I expect this relationship to be even stronger in the

technological sector. A study by Prendergast (2000) shows, that there is a positive relationship

between executive compensation and corporate-risk taking in R&D intensive firms. The

individual characteristics of the technology sector (e.g. short product lifecycles, high required

innovative capacity, high level of uncertainty about the future) suggest, that CEO

compensation packages and corporate risk-taking must have a stronger relationship in these

industries. As Firms use remuneration packages to encourage executives to overcome their

relatively high-level of corporate risk-taking is necessary for them to survive. One popular

example for this phenomenon is Google, who is undoubtedly part of the technology industry.

Google holds massive levels of excess cash in their balance sheet to be able to quickly react

on the market and purchase promising patents or start-up companies. This high level of cash

poses a risk to the company since it looses possible returns from other projects where this

money could be invested (even bank interests). Managers will typically hesitate to take this

kind of risk unless their compensation packages give them incentives to do so. The

technology sector requires firms to take all kinds of risks, like hold high levels of excess cash,

high investments in R&D and for companies with lower possibilities of internal financing

than the big one like Google or Apple, high leverages are also part of this high required level

of risk-taking (Prendergast, 2000; Dee et al., 2005; Coles et al., 2006). To sum up, technology

firms have higher needs for an appropriate level of risk-taking in their corporate

decision-making processes and therefore need to implement better (higher) compensation

packages to meet this need. The sensitivity of corporate risk-taking for CEO compensation is

therefore hypothesized to be higher in the technology sector compared to other sectors. Firms

and executives will both be aware of the highly volatile and risky environment in the

technology sector and the effect of compensation on risk-taking will therefore be higher in

this sector.

H1a:

​ ​CEO compensation has a positive effect on corporate risk-taking.

H1b: The positive effect of CEO compensation on corporate risk-taking is higher for firms in the technology industry compared to other industries.

2.2.2 Firm-level Governance as a moderator of the Compensation-Risk relationship

Firm-level corporate governance measures have to be considered in the examination of the

compensation-risk relationship as they are a primary determinant of a firm’s ability to use

governance tools in order to achieve its goals. A higher level of corporate governance can

fixate corporate executive’s remuneration at a level where it is best in order to serve

shareholder’s interest and prevent or at least minimize the extraction of private benefits by

corporate executives. If firms have high levels of corporate governance, they can more

measures (Coles et al., 2006). The same study suggests, that the extraction of private benefits

by corporate executives, even so far as executives will manipulate firm statements, is much

more likely in the absence of high corporate governance standards. Cyert et al. (2002) find,

that firms can improve their monitoring capabilities with higher levels of corporate

governance and will subsequently arrive at more efficient levels of risk-taking and a better

corporate performance. This relationship is however found to be questionable, as Larcker et

al. (2012) find a positive effects of weaker corporate governance standards of firm

performance. Their research suggests, that the higher monitoring costs that higher corporate governance standards incur will surpass the managerial entrenchment costs that the firm

would be subject to otherwise. This finding is labeled managerial-power hypothesis in the

literature. Derived from these findings, it seems likely that better corporate governance

standards can also lead to a ‘worse-off’-effect in terms of risk-taking as high corporate

governance standards and thereby higher compensation packages to encourage risk-taking

may be more costly for firms than the abandonment of risky, positive NPV-projects by

risk-averse corporate executives. Information asymmetries also play a crucial role in the

effectiveness of corporate governance on the compensation-risk relationship. Managers that

are subject to high corporate governance standards and thereby a high level of monitoring

might chose to withhold valuable information about the firm in order to avoid higher

monitoring levels. Higher corporate governance might therefore lead to higher levels of

information asymmetries. These asymmetries will negatively affect the relationship of

compensation and risk-taking because the design and scope of remuneration packages will

become less optimal. Board members will have less available information in the process of

designing efficient compensation packages. A study by Chan et al. (2008) finds similar results

as they conclude, that managers will react badly if they perceive to be subject to too high

monitoring procedures and they feel forced to satisfy shareholder’s interests. Managers who

feel intimidated by this are likely to engage in earnings manipulation and other managerial

entrenchment practices. Firms with high levels of corporate governance standards allow investors to closely monitor managers and make their voices heard in corporate

decision-making procedures which could lead managers to engage in the aforementioned

practices. Acharya et al. (2013) find, that well-governed firms will be more likely to

efficiently use compensation packages to direct executive’s behavior in a

corporate governance standards do not always lead to efficient levels of CEO-pay as they find

that a considerable proportion of US-firms still overpay their CEOs even under a high level of

corporate governance. This fact is found to be caused by the “market of talent” in the human

resource markets. Managers with high managerial skills are a scarce resource in the market

and this makes their remuneration subject to market-price inflation. Firms will be forced to

pay too high compensations in order to hire high-skilled managers for their company. These

market forces may negatively affect the compensation-risk relationship as firms have to

consider them in the process of pay-determination and cannot simply consider optimal risk

levels for their compensation packages. Motivation effects may also play a role in this respect

as a high level of pay will higher the probability that managers deploy their full set of

capabilities to achieve the shareholder’s long-term goals. A study by _​Randøy _​and ​Nielsen

(2002) reveals a positive mediating effects of corporate governance on the ability of CEO

compensation to overcome agency problems. They find that firm-level corporate governance

measures play a mediating role in the agency problems - CEO power relationship. Differences

in firm-level corporate governance are found to have a significant effect on variations in

corporate executive remuneration packages. Corporate Governance is further found to have a

significant positive effect on a firm’s level of risk-taking. As a study by John et al. (2008)

reveals, corporate risk-taking is closer to the firm’s optimal risk-levels in the presence of high

corporate governance standards. The mentioned studies suggest positive and negative effects

of corporate governance standards on the compensation-risk relationship. In order to evaluate

which one prevails, I hypothesize:

H2a: Firm-level corporate governance positively moderates the relationship between CEO compensation and corporate risk-taking.

H2b: Firm-level corporate governance negatively moderates the relationship between CEO compensation and corporate risk-taking.

The technology sector further poses an interesting subject of study in this respect. The special

characteristics of the technology sector make corporate governance even more important for

firms there. The high levels of uncertainty in the sector and the high level of information

environment makes it very hard for shareholders to efficiently monitor CEO behaviour.

Executives must be able to act very fast and take quick decisions in order to cope with the

high development speed of the market. Corporate governance mechanisms and the implied

higher level of monitoring and more sophisticated and long-lasting decision-making

procedures pose a risk for the company as quick reactions to market-developments are

hampered and long-term success and a growth of shareholder wealth is in danger. A study by

Cheung et al. (2005) finds, that Chinese companies in the technology sector are more likely to

show better corporate performance if they show lower levels of corporate governance. Higher

corporate governance standards will have a negative effect on the efficiency of remuneration

packages in optimizing a firm’s risk level according to these findings, because they will

increase managerial entrenchment and decrease efficiency levels in the firm. Especially in the

dynamic technology environment, quick reactions to market developments and technological

breakthroughs are essential, and high governance will hamper them and subsequently

negatively influence the efficiency of remuneration packages to optimize and increase

corporate levels of risk-taking. Executives will feel intimidated by the high level of scrutiny

and will therefore be more reluctant to take the high levels of risk that are especially needed in

the technology sector.

However, Balkin et al. (2000) find, that high levels of corporate governance are essential for

technology firms in order to achieve shareholder goals. As the “DotCom-bubble” and the

destruction of massive amounts of shareholder wealth show, technology firms and their

success can be very short-lasting and unsustainable. High levels of corporate governance are

therefore required to ensure a minimization of information asymmetries in the sector.

Shareholders need close monitoring mechanisms to ensure they obtain the required

informations to evaluate the corporate executive’s performance and subsequently the outlooks

for success of their own investments. Higher corporate governance is therefore an efficient

tool to optimize the efficiency of remuneration packages to derive at optimal levels of

corporate risk.

H2c: The moderating effect of firm-level corporate governance is more positive for firms in the technology industry compared to other industries.

H2d: The moderating effect of firm-level corporate governance is more negative for firms in the technology industry compared to other industries.

2.2.3 Country-level Governance as a moderator of the Compensation-Risk relationship

Not only firm-level governance has an influence on the relationship of compensation and

corporate risk-taking, but also country-level governance indicators (Hansen et al., 2012).

Randoy and Nielsen (2012) conducted a study amongst scandinavian firms and found, that

country-level variables play a crucial role in the determination of CEO compensation

packages. They show that several country characteristics like investor protection are good

predictors for the level of CEO compensation in a country. Houston et al. (2010) further find

an effect of country-level variables on the average level of corporate risk-taking across countries. They conclude that the pay-performance sensitivity is largely affected by

cross-country variables. This study will extend this definition and examine the effect of

country-level characteristics on the pay-risk sensitivity. Klapper and Love (2004) examine the

effect of various country characteristics on CEO pay and find positive effects of law

enforcement and investor protection regimes. A study by Albuquerque (2013) shows that

country-level corporate governance is one of the main determinants of firm-level governance.

He further finds complementary effects of country-level governance on firm-level governance

and thereby further suggests interlinkage-effects between the two levels of governance.

A study by Hansen et al. (2012) emphasizes the special importance of investor protection for

the mentioned relationship. Investor protection is defined as the degree of minority shareholders and creditors’ rights and interests being protected by legislation from insiders’

expropriation, such as mandatory disclosure of accounting information, gaining dividends,

and voting rights etc. (La Porta et al., 2000). Many researchers have emphasized the

importance of investor protection, such as La Porta et al. (2000), since the lack of minority

shareholders’ protection, caused by poor corporate governance, would lead to a high cost of

capital. The work of La Porta et al. (2000) shows that there are stronger investor protection

protection systems are found in code law countries, for example, France, Germany and

Scandinavian countries. In a study of Morck et al. (2000), they find that there is a relationship

between the quality of investor protection and the level of informed risk arbitrage.

Furthermore, inefficient production and low growth rate would be caused by a low level of

informed risk arbitrage in bad investor protection countries (Durnev et al., 2004). John et al.

(2008) note that not only management behavior and executives compensation have an impact

on corporate risk-taking, but also investor protection, and a positive relationship between

corporate risk-taking and the quality of investor protection was found in their research.

According to agency theory, managers would reject some positive-NPV projects to protect

their own interests, but this does harm to investors’ benefits, especially minority shareholders

(Jensen & Meckling, 1976). Besides, John et al. (2008) point out that the alignment of

interests between shareholders and managers could be achieved under the environment of

strong investor protection, causing higher risk-taking by managers. The literature defines this

phenomenon as the incentive-alignment theory. Furthermore, stakeholders have bigger

impacts on firms when they operate in countries with poor investor protection. So managers

will take less risk due to the pressure from these stakeholders (John et al., 2008). Investor

protection will encourage decision-makers to take higher risk, and invest in riskier projects

with higher expected returns (Stulz, 1999; Klapper & Love, 2004; John et al., 2008; Houston

et al., 2010). However, there are also some studies suggesting a negative relation between

investor protection and corporate risk taking. For instance, the work of Paligorova (2010)

states that the number of dominant shareholders will be less in good investor protection

countries, which offers risk-averse agents more opportunities to avoid corporate risk, since

ownership concentration and investor protection complement each other. Additionally, shareholders’ concerns about the expropriation by managers will decline when those

shareholders’ rights are defended in countries with stronger investor protection (Paligorova,

2010).

Additionally, some researchers note that the quality of investor protection will also affect

CEO compensation (e.g. Hartzell & Starks, 2003; Arye Bebchuk & Fried, 2004; _​Frieder &

Subrahmanyam, 2006; Albuquerque & Miao, 2013; _​Zheng et al., 2016). As Zheng et al.

(2016) point out, there is a significant positive relationship between investor protection and

private interests will decrease and they will receive more explicit incentives to induce them to

create more profits under the environment of stronger investor protection (Zheng et al., 2016).

The work of Arye et al. (2003) claims, that managers have no choice but to waive some of

their private benefits under better investor protection, so improving executives pay will make

up for the loss of their private interests and it will lead to higher efficiency of the firm under

stronger investor protection. Moreover, La Porta et al. (2000) indicate that the quality of

investor protection is related to corporate governance, which includes executives

compensation system. This paper argues that investor protection has a moderating effect on

the relationship between executives compensation and corporate risk-taking. Considering the

effect of the quality of investor protection on executives compensation and corporate risk

taking and the ambiguous views of the literature on this relationship, the third hypothesis is

developed as follows:

H3a: Country-level governance and specifically the level of investor-protection positively moderates the relationship between CEO compensation and corporate risk-taking.

H3b: Country-level governance and specifically the level of investor-protection negatively moderates the relationship between CEO compensation and corporate risk-taking.

In line with the preceding chapters, this study will take a closer look on the special

characteristics of the technology industry and their impact on the hypothesis. As mentioned

before, the technology sector is characterized by high levels of uncertainty and a high

competition dynamics within the industry. The moderating effect of country-level governance

and specifically investor-protection should either be stronger due to higher agency problems

or weaker due to the mentioned effects of increasing information asymmetries and the

executives’ perceived pressures of shareholders that force them to act in their interest. The

same argumentation as for firm-level corporate governance indicators applies here since

country-level governance is the main determinant of shareholder’s ability to implement

H3c: The positive moderating effect of country-level governance and specifically the level of investor protection is stronger for firms in the technology industry compared to other industries.

H3d: The negative moderating effect of country-level governance and specifically the level of investor protection is stronger for firms in the technology industry compared to other industries.

2.2.4 Cultural Dimensions as moderators of the Compensation-Risk relationship

Previous research suggest that national culture has an influence on management control

systems and corporate governance practices, such as executives compensation structure (e.g.

Hofstede et al., 1991; Chow et al., 1999; Van der Stede, 2003; Jansen et al., 2009;

Greckhamer, 2011). Hofstede et al. (1991) identified five cultural dimensions, including

power distance, individualism, uncertainty avoidance, masculinity, and long-term orientation.

Managers may prefer performance-based pay and focus on personal achievement in countries

with higher levels of individualism, while those managers have higher possibility to prefer a

more stable fixed pay in countries with lower level of individualism (Chow et al., 1999). In

some Anglo-Saxon countries like the U.S., CEOs pay more attention to production efficiency

and organizational performance due to the high level of individualism and masculinity,

whereas people from Continental-European countries, Dutch managers, for example, receive

less incentive income than American managers due to long-term oriented national culture

(Jansen et al., 2009). As the work of Jansen et al. (2009) notes, even when Dutch firms

implement incentive compensation, they didn’t get satisfying feedback or positive effects on

firm value. Besides the fact, that the U.S. has a higher level of masculinity but lower levels of

long-term orientation according to Hofstede (1980), it is explained why American managers

prefer stock options and other equity-based compensation than managers from other countries.

Jansen et al. (2009) argue that uncertainty and individualism cultural dimensions have the

most critical influence on the design of executives compensation. According to Van der Stede

(2003), uncertainty avoidance is defined as how much people hate, or feel frustrated by an

in countries with high level of uncertainty avoidance, as performance-based pay is more

unstable and risky (Van der Stede, 2003). In terms of the individualism dimension, Van der

Stede (2003) notes that it represents the trend of a person to regard himself as an individual

instead of a member of a community. Chow et al. (1999) propose, that people would rather

get performance-based compensation than clearly formula-based salary since

performance-based incentives offer them a sense of achievement and people focus on personal

value in individualistic societies.

In the meantime, national culture will also affect corporate risk-taking according to Schuler

and Rogovsky (1998). Managers are less likely to invest in highly risky projects in countries

with high level of uncertainty avoidance, while those managers would like to take more

corporate risk in countries with lower level of uncertainty avoidance. Slocum and Lei (1993)

observe that American CEOs would take higher corporate risk when managing firms since the

U.S. has lower scores in uncertainty avoidance. In countries with higher level of uncertainty

avoidance, managers are less likely to prefer performance-based compensation due to its

riskiness (Harrison et al., 1994). According to the argument discussed above, considering

cross-culture variables have influence both on CEO compensation and risk taking, this thesis

argues that national culture also has an effect on the relation between CEO compensation and

risk taking, especially uncertainty avoidance and individualism dimensions. So the fourth hypothesis is developed as follows:

H4a: The level of uncertainty avoidance moderates the relationship between CEO compensation and corporate risk-taking.

H4b: The level of individualism moderates the relationship between CEO compensation and corporate risk-taking.

The technology sector and its special risk characteristics further justify a special look at the

sector in terms of culture. As the word already indicates, uncertainty avoidance is highly

associated with risks and the avoidance of them. It can therefore be hypothesized, that the

effect of uncertainty avoidance on the relationship between executive compensation and

of managers and shareholders make it even more important to achieve efficient risk-taking through specific compensation packages. One can therefore assume that the effect of

compensation on corporate risk-taking is higher in uncertainty avoiding environments.

Technology firms in these environments have a higher need for an efficient direction of

corporate risk-taking by compensation packages. On the other hand, one can imagine a natural

selection process for industry sectors and the executives working there. Since the higher levels

of risk in this industry are widely known amongst managers, one can assume that risk-averse

managers will avoid positions in the technology sector and prefer other industries. This

re-allocation of risk-averse managers to other industry sectors would undermine and minimize

the effects of uncertainty avoidance on the compensation-risk relationship and drive them up

in other industries since risk-averse managers will gather there. Consequently, I hypothesize

H4c: The moderating effect of uncertainty avoidance is stronger for firms in the technology industry compared to other industries.

H4d: The moderating effect of uncertainty avoidance is weaker for firms in the technology industry compared to other industries.

Figure 1. Conceptual model

3. Methodology, Data and Sample

To examine the hypothesis above, the linear regression method is used to implement the

estimation of the unbalanced panel dataset. All relevant variables are presented in the

following subsections.This thesis examines the relationship between CEO compensation and

corporate risk-taking in technological industry. Further, industry-effects, country-level effects

are also to be studied in this thesis. The sample period is from 2002-2015. And panel data

analysis would be used in order to test the hypothesis discussed above. All variables examined

in this thesis to research the relation between CEO pay and risk-taking will be reported in this

section.

3.1.1 Dependent variable

According to previous research, there are several way to measure corporate risk-taking, such

as leverage, R&D intensity, and stock return volatility, etc. (An et al., 2014; Coles et al.,

2006). The dependent variable in this thesis is the level of corporate risk-taking. And _​this

risk-taking, following the way of An et al. (2014). To be specific, SROA is calculated as the

standard deviation of EBITDA to total assets over past 3 years, which is commonly used as a

proxy for risk-taking in previous research (e.g., An et al., 2014). And R&D intensity is

measured as the ratio of R&D expenditure to total assets (Coles et al., 2006).

SROA = natural logarithm of (standard deviation of (EBITDA / total assets) for past 3 years )

R&D spending is another common proxy for corporate risk-taking since R&D projects are

highly risky investments (Balkin et al., 2000). But the amount of R&D spending varies a lot

from firm to firm, depending on many conditions of firms, such as their size, profitability,

industry characteristics, etc. Hence this thesis uses the percentage of R&D spending to total

assets to make it comparable, as shown in the following formula:

RD = natural logarithm of ( R&D expenditures / total assets )

3.1.2 Independent variable

Previous research have used many ways to measure CEO compensation, such as cash

compensation, total CEO compensation, the value of stock options compensation, the ratio of

equity-based compensation to total CEO compensation, etc. (Aggarwal & Samwick, 1998;

Coles et al., 2006; Dee et al., 2005).Since studies about executives compensation packages

have attracted much attention, the number and detail of compensation data have improved

greatly (Anderson et al., 2000). This thesis uses CEO total compensation (including base

salary, bonus, the value of stock options and restricted shares ) and total stock options

compensation as the independent variables, and regression models will explore the influence

of CEO compensation on corporate risk-taking. The data for these independent variables

could be collected from ASSET4 ESG database. The ASSET4 ESG database include data in

terms of 4 perspectives: environment, economy, society, and corporate governance. This

database includes almost 750 individual assessment score for each listed company, which

generates more than 250 important performance index (Gonenc & Scholtens, 2017). And

those data were collected from many public sources, including financial reports and corporate

websites (Gonenc & Scholtens, 2017). I collected the data for executives compensation from

corporate governance (Cyert et al., 2002). The score and value for companies’ operation and

governance are gathered in corporate governance pillar, which evaluates the quality of board,

managers compensation, etc. Considering the availability of data in ASSET4 ESG of

datastream, I collected total executives compensation and total stock options compensation as

independent variables and define them as following formula since the value of compensation

is quite big compared to dependent variables (SROA and RD):

COMP = natural logarithm of total executives compensation

OPTION = natural logarithm of total stock options compensation

3.1.3 Firm-level corporate governance variables

This thesis also includes corporate governance score as a proxy for firm-level corporate

governance characteristics to evaluate the quality of corporate governance in firms and the

data can be collected from ASSET4 ESG database. And corporate governance score offers a

tool to evaluate the degree of protecting stakeholders’ benefits. Therefore, this study will

research the moderating effect of firm-level corporate governance CGS on

Compensation-Risk relationship using the following formula:

CGS = Corporate Governance Score

3.1.4 Country-level variables

This thesis uses the level of investor protection as a proxy for country-level characteristics,

which means the level of protection for investors against resources expropriated by agents It is

measured by the anti-self-dealing index, which is gathered from the paper of Djankov et al.

(2008). This paper provides the data for anti-self-dealing index for 72 countries, which is

established on the work of La Porta et al. (2000) and the index of anti-director rights.

However, anti-self-dealing index is superior to anti-director rights index according to Djankov

et al. (2008), as it evaluates the difficulties that happen to investors when starting a new

transaction gathered from questionnaire. Therefore, this study uses anti-self-dealing index to

In terms of national culture dimensions, Hofstede developed various index for different

countries and he established his own website to present the outcome of his study. Thus the

data for individualism and uncertainty avoidance index is collected from Geert Hofstede’s

website _{​https://geert-hofstede.com/cultural-dimensions.html​. I adopt these index to measure}

national culture dimensions of individualism and uncertainty avoidance in this thesis. And I

use UA as uncertainty avoidance, IND for individualism.

3.1.5 Control variables

This thesis uses some control variables determining financial positions and investment

opportunities, which are established on previous literature (Fernandes et al., 2011; De Cesari

et al., 2016). Those control variables act for the driving forces which link CEO compensation

with financial positions and investment opportunities. This thesis uses the natural logarithm of

total assets to control firm size, which is a common proxy for firm size. According to

Fernandes et al. (2011), there is less possibility for large firms to take higher risk and firm size

also affects the level of CEO compensation. Additionally, Market-to-Book ratio is frequently

used as a proxy for firm growth and investment opportunities (Coles et al., 2006). And this

proxy is measured by the ratio of market value of assets to book value of assets in this thesis.

To control country-level characteristics, GDP per capita is also included as one of the control

variables in this study, calculating by natural logarithm of GDP per capita in each country.

According to Croci et al. (2012), executives will get a greater level of compensation when

there is a bigger board size in firms, which means that executives compensation is positively

affected by board size. This thesis defines Board size as the number of executive directors and

the number of non-executive directors following the method of Croci et al. (2012).

Additionally, Fernandes et al. (2011) suggest that the level of Board independence has an

impact on managers’ compensation and there is a positive relation between the level of

executives compensation and the percentage of independent board members. And those data

could be gathered from ASSET4 ESG database in Datastream. It is measured as the ratio of

the number of independent board members to the total number of board members. The

following formula are the way this thesis defines those control variables: