[We show that, in the presence of correlated investment opportunities across firms, risk sharing between firm shareholders and firm managers leads to compensation contracts that include relative performance evaluation. These contracts bias investment choices toward correlated investment opportunities, and thus create systemic risk. Furthermore, we show that leverage amplifies all such effects. In the context of the banking industry, we analyze recent policy recommendations for firm managerial pay and show how shareholders optimally undo the policies’ intended effects.]

We show that, in the presence of correlated investment opportunities across firms, risk sharing between firm shareholders and firm managers leads to compensation contracts that include relative performance evaluation. These contracts bias investment choices toward correlated investment opportunities, and thus create systemic risk. Furthermore, we show that leverage amplifies all such effects. In the context of the banking industry, we analyze recent policy recommendations for firm managerial pay and show how shareholders optimally undo the policies’ intended effects. Received October 31, 2017; editorial decision August 21, 2018 by Editor Wei Jiang.

We test the hypothesis that foreign direct investment promotes corporate governance spillovers in the host country. Using firm-level data from 64 countries during the period 2005–2014, we find that cross-border M&A activity is associated with subsequent improvements in the governance of nontarget firms when the acquirer country has stronger investor protection than the target country. The effect is more pronounced when the target industry is more competitive. Cross-border M&As are also associated with increases in investment and valuation of nontarget firms. Alternative explanations, such as access to global financial markets and cultural similarities, do not appear to explain our findings. Received October 27, 2015; editorial decision March 25, 2018 by Editor Andrew Karolyi.