Monitoring Versus Crowding-Out Effect: The Role of Social Capital in Managerial Compensation

Abstract

Agency theory predicts that tighter monitoring can motivate managers to exert higher effort. However, psychology theory suggests that managers may perceive increased monitoring as an indication of distrust, thereby reducing their effort level -- known as a crowding-out effect. Prior research on the role of the crowding-out effect in incentive contracting is limited. To fill this void, we first develop a theoretical model with moral hazard and predict that incentive pay is decreasing in the effectiveness of monitoring. Using social capital as a proxy for the trust between firms and CEOs, we hypothesize and find that social capital is negatively associated with the proportion of incentive pay, suggesting that social capital mitigates the crowding-out effect created by increased monitoring. We further show that this negative association is more pronounced for firms with stronger boards, higher accounting quality, and Big 4 auditors, indicating that the effect of social capital on managerial compensation is greater when stronger monitoring intensifies the crowding-out effect. Our results are robust to controlling for headquarters relocations, alternative measures of social capital and incentive pay, additional corporate governance and firm characteristics, and regional fixed effects. Taken together, our evidence suggests that: 1) while not directly observable, the crowding-out effect does play an important role in incentive contracting; and 2) social capital alleviates the crowding-out effect through enhancing the mutual trust between the firm and the CEO.