Compensation Policy in Banking: The Case of Tournament Incentives

We consider the impact of tournament incentives on firm performance. To proxy high-powered tournament incentives, we construct a CEO pay gap as the difference in pay between the highest-earning executive and other officers. Our robust empirical evidence unambiguously demonstrates that high-powered tournament incentives lead to higher levels of firm profitability after controlling for the level of pay and other executive and firm-level characteristics. This result can inform the design of firms’ compensation policy and we recommend firms use vertical pay practices to motivate effort and realise firms’ organisational goals. We fail to support the opposing conjecture that large pay gaps could fuel tensions among executives that could retard firm performance.