Agency Theory Versus Managerial Ownership Theories: Understanding the Non-Linear Relationship between Managerial Incentives and Firm Risk

This paper provides new evidence on the relationship between managerial incentives and firm risk using a hand-collected database of 3307 executive year observations. We find that the relation between pay performance sensitivity and firm risk exhibits a nonlinear relationship with firm size: for small to medium-sized quoted companies there is a negative relation between pay performance sensitivity and risk consistent with the standard agency theory model; but for large quoted companies the relationship becomes unstable under different model specifications. We argue that the model of compensation practices advanced by Aggarwal and Samwick (1999) does not apply to all ranges of the company size distribution and, indeed, for all types of directors. Also, the support found for the model advanced by Core and Guay (2001) is not robust to different model specifications. We conclude that neither model can fully explain the relationship between pay performance sensitivity and risk in the UK.