Complementarity in Monitoring and Bonding: More Intense Monitoring Leads to Higher Executive Compensation

Executive Overview Agency theory addresses problems created from the separation of principals and agents in modern corporations. Some agency theorists have investigated the exact relationship between control mechanisms (monitoring and bonding) and suggested that they work as substitutes. We posit that, although monitoring and bonding may be concurrent substitutes in a system of governance, monitoring intensity is positively related to bonding (i.e., compensation) so that over time, they are complements rather than substitutes. In particular, we suggest that increased monitoring intensity shifts risk to managers, who then require greater compensation to offset their increased employment and career risk. Accordingly, they reinforce each other in a negative cycle such that monitoring leads to increased pay, which in turn leads to increased monitoring due to complaints of excessive pay. The result is that in today's economic environment society often criticizes executive pay without realizing that, in part, higher compensation is an outcome of prior increased monitoring intensity. These findings are particularly important as elected officials are increasingly under pressure to monitor and limit executive compensation. An understanding of this relationship also has implications for executive risk taking and entrepreneurial activities.