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Journal ArticleDOI

Executive compensation, corporate governance and corporate performance: A simultaneous equation approach

01 Mar 2015-Managerial and Decision Economics (Wiley)-Vol. 36, Iss: 2, pp 67-96

Abstract: This paper investigates the association between executive compensation and performance. It uniquely utilises a comprehensive set of corporate governance mechanisms within a three-stage least squares (3SLS) simultaneous equation framework. Results based on estimating a conventional single equation model indicate that the executive pay and performance sensitivity is relatively weak, whereas those based on estimating a 3SLS model generally suggest improved executive pay and performance sensitivity. Our findings highlight the need for future research to control for possible simultaneous interdependencies when estimating the executive pay and performance link. The findings are generally robust across a raft of econometric models that control for different types of endogeneities, executive pay and performance proxies. Copyright © 2013 John Wiley & Sons, Ltd.

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University of Huddersfield Repository
Ntim, Collins G., Lindop, Sarah, Osei, Kofi A. and Thomas, Dennis A.
Executive Compensation, Corporate Governance and Corporate Performance: A Simultaneous
Equation Approach
Original Citation
Ntim, Collins G., Lindop, Sarah, Osei, Kofi A. and Thomas, Dennis A. (2015) Executive
Compensation, Corporate Governance and Corporate Performance: A Simultaneous Equation
Approach. Managerial and Decision Economics, 36 (2). pp. 67-96. ISSN 01436570
This version is available at http://eprints.hud.ac.uk/id/eprint/19536/
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Executive Compensation, Corporate Governance and Corporate Performance: A
Simultaneous Equation Approach
Collins G. Ntim
a
, Sarah Lindop
b
, Kofi A. Osei
c
, and Dennis A. Thomas
b
a
School of Management
University of Southampton
Southampton, UK
b
School of Management and Business
Aberystwyth University
Aberystwyth, UK
c
Department of Finance
University of Ghana Business School
University of Ghana
Accra, Ghana
Corresponding author. Address for correspondence: Centre for Research in Accounting, Accountability and
Governance, School of Management, University of Southampton, Southampton, SO17 1BJ, UK. Tel: +44 (0) 238
059 8612. Fax: +44 (0) 238 059 3844. E-mail: c.g.ntim@soton.ac.uk.

Executive Compensation, Corporate Governance and Corporate Performance: A Simultaneous
Equation Approach
Abstract
This paper investigates the association between executive compensation and performance. It uniquely
utilises a comprehensive set of corporate governance mechanisms within a three-stage least squares
(3SLS) simultaneous equation framework. Results based on estimating a conventional single equation
model indicate that the executive pay and performance sensitivity is relatively weak, whereas those
based on estimating a 3SLS model generally suggest improved executive pay and performance
sensitivity. Our findings highlight the need for future research to control for possible simultaneous
interdependencies when estimating the executive pay and performance link. The findings are generally
robust across a raft of econometric models that control for different types of endogeneities, executive
pay and performance proxies.
JEL Classification: G32; G34; G38
Keywords: Executive compensation; Corporate performance; Corporate governance; Simultaneous
equation; Generalised method of moments (GMM); Endogeneity

1
1. INTRODUCTION
Jensen and Murphy (1990) suggest that through optimal contracting, executive pay, especially that
involving equity/performance-linked compensation, can limit agency problems by aligning the interests of
managers and shareholders. However, the recent global financial crisis precipitated by increased risk-taking
and pay motives of top executives of major banks (Tung, 2010; Aebi et al., 2011; Lin et al., 2012;
Paligorova, 2011; Tang, 2012; Polat and Nisar, 2013; Wesep and Wang, 2013) has reignited the debate
regarding the effectiveness of executive compensation packages in mitigating agency conflicts in modern
corporations (Goering, 1996; Murphy, 1997; Grundy and Li, 2010; Van Essen et al., 2012; Berger et al.,
2013; Cook and Burress, 2013). Whilst a number of papers have examined the link between executive pay
and corporate performance, the general conclusion is that the link is weak (Murphy, 1999; Canarella and
Nourayi, 2008; Dong et al., 2010; Elsila et al., 2013; Kabir et al., 2013; Tiani, 2013).
A number of reasons may explain the weak findings of past studies. First, since executive pay is just
one of the possible corporate governance (CG) mechanisms that companies can employ to minimise agency
conflicts (Mehran, 1995; Borisova et al., 2012; Huang et al., 2012), its effectiveness may depend on the
simultaneous use of other CG mechanisms (Agrawal and Knoeber, 1996; Chung and Pruitt, 1996; Beiner et
al., 2004, 2006; Livne et al., 2013; OConnor et al., 2013). A major implication of this is that estimating the
executive pay and corporate performance sensitivity through the use of single equation modelling
techniques can result in endogenous associations (Core et al., 1999; Larcker and Rusticus, 2010; Connelly
et al., 2012; Gil-Alana et al., 2012; Bai and Elyasiani, 2013). Existing studies, however, have mainly used
single equation modelling, and thereby crucially ignored endogeneity problems that may be posed by the
possible simultaneous use of alternative CG mechanisms in estimating the executive pay and corporate
performance sensitivity (Guest, 2009; Wintoki et al., 2012; Zhao, 2013).
Second, the extant literature has focused mostly on cash-based rather than equity-based executive
compensation (Conyon, 1997; Benito and Conyon, 1999; Kato and Long, 2006; Buck et al., 2008; Shen and
Zhang, 2013). In contrast, corporate performance is more sensitive to equity-based than cash-based
executive compensation (Jensen and Murphy, 1990; Main et al., 1996; Cosh and Hughes, 1997; Ozkan,

2
2011), and this may also explain the weak findings of past studies. Third, Main (1991), Lewellen et al.
(1992), Conyon and Murphy (2000) and Firth et al. (2006, 2007) show that executive pay differs
substantially across countries due to variations in legal, institutional, cultural and CG practices.
However, past studies are concentrated in the UK and US, presenting comparatively similar
institutional contexts (Ang et al., 2002; Anderson and Bizjak, 2003; Chen et al., 2006; Cunat and
Guadalupe, 2009; Sun et al., 2009). In developing countries with different institutional settings, with
particular regard to CG reforms, ownership structures and executive director compensation incentives, the
link between executive pay and corporate performance can be expected to differ from what has been found
in industrialised countries. As such, studying the association between executive pay and corporate
performance in developing countries, where empirical evidence has been limited, contributes to a more
complete understanding of the relationship between executive compensation and corporate performance. A
major reason for the paucity of empirical evidence in developing countries, especially African countries, is
the difficulty in obtaining data of sufficient frequency and duration for analysis (Okeahalam, 2004;
Mangena and Chamisa, 2008; Mangena et al.,2012; Ntim et al., 2012a; Fosu, 2013).
Recent CG reforms in South Africa (SA), however, provide a unique and potentially rewarding context
for such a contribution. The recent South African CG reforms incorporate the expectation that executive
pay will be strongly linked to corporate performance, and also require listed firms to fully disclose
executive compensation details in their annual reports, making available information that hitherto has been
publicly inaccessible. This development provides the opportunity to collect data on total pay of the Chief
Executive Officer (CEO), as well as on the total pay of all executives and on CG in order to investigate the
association between executive compensation and performance for a sample of SA listed companies,
enabling us to make a number of contributions to the extant literature.
The paper documents for the first time evidence on the levels of executive pay, as well as the
association between executive compensation and corporate performance in SA. Distinct from most past
studies, we provide evidence on how corporate performance is associated with both the total pay of the
CEO and that of all other executives, as well as on the link between cash (i.e., salary, performance bonus,

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