The bounded incentive effect of informal institutions

Purpose: This paper aims to mainly investigate the role of trust, which is an important informal system, in executive compensation incentives. Design/methodology/approach: Using the data of Chinese A-share private enterprises from 2003 to 2014, the paper estimates the effect that trust has on executive compensation incentives. Findings: Results indicate that trust can significantly enhance the effectiveness of executive compensation incentives. Furthermore, the better the regional trust environment in which companies are located, the more pronounced the effect is. In particular, the effect of trust on executive compensation incentives is only significant when the formal legal system is immature. As companies continue to grow and develop and the formal system becomes perfect, the role of trust weakens. The formal system, including the corporate governance mechanism and perfect legislation, then becomes the key to promoting executive compensation incentives. Practical implications: This paper provides evidence of the significance of both informal and formal systems. It not only emphasises the important role that the informal system has played in “the mystery of China’s economic growth” but also supports the “ruling the country by law” strategy for the sustainable development of China’s economy. Originality/value: This paper reveals the relationship between the formal and informal systems, which provides a new perspective on and empirical evidence for the determinants of executive compensation incentives, and it also finds an explanation for the rapid growth of China’s economic development.