The Empirical Tests of the Regulated Industry Hypothesis(RIH):The Case of Stock Option System

Previous studies on the relation between a managerial compensation system and the value of a firm suggest that stock option plans might not be effective in increasing the value of firms in the highly regulated industries, such as banks, insurance and utilities companies. In addition, the government regulation plays such a role that the firms under heavy regulation can behave differently from firms under milder regulation in the major financial decisions, such as risk taking in the capital budgeting and income distribution policy. This is so-called Regulated Industry Hypothesis (RIH). Although there are many studies that deal with regulation issues in the area of financial economics, it is not easy to find the research regarding the role of regulation in the context of the stock option system and financial decision makings as Yermack (1995, 1997) points out. Therefore, in this study, we empirically analyze the influence of government regulations on the effectiveness of stock option plans for the Korean capital markets which are known as far more regulated by the government than other developed countries. From the analyses, we find that the stock option plan has a very limited and even negative effect in enhancing a firm's value for regulated firms, while the effect is significantly positive for the non-regulated firms. This implies that the stock option system should be carefully applied to the regulated firms, if the purpose of the system is to increase the wealth of the shareholders. In addition, our results show that the shortterm risk and dividends have been significantly increased and decreased, respectively, for the regulated firms, while significant changes were not found for non-regulated firms. These results imply not only that stock options are not an effective compensation mechanism in enhancing firm value, but also that the introduction of stock options to the regulated firms simply increases the agency costs by inducing the increase of the risk and the decrease of the dividends. Therefore, highly regulated firms should take into account these results when they consider introducing stock option system as a way of a value management. In conclusion, this study empirically demonstrates that the regulated industry hypothesis is also valid in the compensation system of a company, such as stock option, and shareholders(owners) of the regulated firms should aware this implication to maximize their wealth when managers(agents) of the firms make crucial decisions in finance and investment