The 'three reference point' effect and the role of political connection in executive compensation : empirical studies on Chinese listed firms

• Main Author: Gao, Ya
• Other Authors: Chen, Jean; Li, Gang
• Published: University of Surrey 2015
• Subjects: 658
• Online Access: http://ethos.bl.uk/OrderDetails.do?uin=uk.bl.ethos.655533

Agency theory has for some time been the dominant on executive compensation research. Behavioural approaches such as prospect theory, behavioural agency theory and reference point theory (including strategic reference point theory) provide new perspectives for research into executive compensation. For the largest transitional economy of China, the shift from a planned and administration-oriented economy to a market-oriented economy remains an on-going process. As behavioural approaches are derived from the understanding of human decision-making patterns, they are therefore less subject to institutional settings and thus more applicable to understanding executive compensation contracting in China. From a reference point theory perspective, we test a ‘three reference point’ framework for executive compensation contracting: in external reference to peer firms, internally to other executives on board, and in the time dimension referring to top executives’ previous pay. We find that as a superior alternative to agency theory, reference point theory can provide a better explanation for top executive compensation contracting. In our three empirical chapters, we mainly find that: (1) Chinese executive pay levels are externally heavily influenced in their setting by the pay level of executive peer groups; internally by other executives within firms and by the pay level of an individual executive in the previous period. It should also be noted that the loss aversion effect exists in top executive compensation contracting. (2) We test the three reference point effect and use Principal Component Analysis (PCA) to determine the systematic effects of these reference points to empirically test the behavioural determinants of executive pay in China; the three reference points and the systematic effect on top executive compensation are determined to be robust. (3) We document a negative association between top executive pay and a politically-connected board. However, after controlling for the three reference points, this association becomes positive and further strengthens the pay-performance link. We also find that in state-owned and politically connected firms the pay–performance link is the strongest, especially after adjusting for the effect of the three reference points. In private firms that are not politically connected, meanwhile, the pay-for-performance link is weak. Our findings have important policy implications. They highlight the defects of current corporate governance mechanisms, particularly in executive compensation design and monitoring. The current Chinese Corporate Governance Code largely mimics corporate governance practice in the Anglo-American business environment and relies heavily on agency theory; therefore, to a large extent, it does not work in its own context. Our findings identify that in practice, the ‘three reference point’ framework and political connections play very important roles in influencing Chinese executive pay setting, in addition to the link to pay-for-performance and corporate governance mechanisms. It is therefore indicated that the Chinese Government should consider developing policies and regulations in addition to its Corporate Governance Code in order to effectively control the problems of the departure of executive compensation from firm performance.