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Gerwin van der Laan: Mayday, mayday, it is pay day!

When ING Bank proposed to increase its chief executive officer's (CEO) pay from two to three million euros, an intense debate was sparked, eventually leading to the withdrawal of the proposal. The arguments for and (mostly) against the proposal were the usual suspects, yet new insights went hidden just below the surface.

Economists are often put on the spot to explain compensation. The supply of and demand for executive talent like ING's Ralph Hamers should affect pay. It is unlikely that Hamers's knowledge and skills unexpectedly turn out to be much more valuable than ING anticipated, nor is it likely that managing the bank now is radically different from managing it some months ago. Economists thus seem to have no justification for the increase in pay. This is not surprising, as the market for executive talent does not function too well. I am yet to come across the first firm which opts not to hire a CEO because they are too expensive, or one that hires two because the price was an attractive deal. Instead of market forces, a comparison with peers is more likely to determine compensation.

No, they can’t!

This comparison is what Kilian Wawoe refers to as the 'Blaricum effect'. In the relatively wealthy Dutch city of Blaricum, a rich citizen by objective standards can feel poor because he only sees more wealthy citizens around him. In the board room, a well-paid executive could perceive himself as not too well off, because his colleagues are being paid more. Indeed, the pay increase at ING was motivated by ING's low position in compensation rankings. If we want to break through the Blaricum effect, what can we do? How can we force executives to compare themselves to more reasonable standards? Cap compensation, politicians say. Give the Minister of Finance veto power!

The law has vested the power to propose compensation policies in the (supervisory) board of directors. This board is mandated to supervise management in the interest of the business and should thus be well-positioned to keep greedy managers in line. Specifically if it comes to compensation, many countries also give owners a say on pay. Unfortunately, owners often do not care. As long as ING makes billions in profits, a milion more or less in pay is peanuts to an owner. Most companies have complex compensation systems, and (part time) supervisors may find it difficult to comprehend it fully. It is quite a stretch, though, to assume that the Ministry of Finance would. Whose interests would the Ministry be looking after? Would the Ministry have the expertise to understand both the specifics of the company and the technicalities of pay systems? Why would the Ministry care? Giving politics a veto in executive compensation merely shifts the problem and does not ensure a solution.

Yes, we can!

In the past fifteen years, managerial power theory has become increasingly popular to explain compensation. In the absence of caring owners and directors who are willing and able to act with force, this theory says, managers essentially determine their own pay. The complexity of the pay system allows them to camouflage pay practices. Outside audiences simply do not notice. However, at some point, these audiences will notice and outrage will result. It is the anticipation of outrage that restricts compensation. It is an appealing theory, which is difficult to test in practice. Yet the observation that ING withdrew its proposal exactly because of societal unrest, is an indication that it may be a relevant theory. What would this imply for the debate?

If outrage restricts compensation, outrageous compensation is the result of our unwillingness to act. If we would be willing to relocate our banking activities when we disagree with the CEO's pay, there is a clear business case to reduce pay. If workers would be willing to seek employment when the policy of the business violates their principles, real change is possible. If suppliers would be willing not to sell to companies whose pay practices it disapproves of, change is on its way. As with any corporate social irresponsibility: if buyers, employees and suppliers put their money where their mouth is, excessive pay may no longer be possible. That is not to say that they are responsible for pay setting, but it does indicate that we should not underestimate our own ability to effectuate change in business.

Gerwin van der Laan – program director Business and Economics at University College Tilburg