TL;DR: (1) Banning stock incentives overall would decrease company performance. (2) banning stock options specifically (e.g. in favor of restricted stock grants or indexed options) is likely to improve long term performance, by reducing risks taken and short term actions.
First, let's discuss why stock incentives are there.
Because, in a typical corporate structure, CEO is merely an employee hired by the shareholders' board of directors - in other words, he's supposed to do what's best for shareholders by the nature of the job - whether CEO themselves is a shareholder or not does not change that, but it changes their incentive to try extra hard to do what they are supposed to.
The purpose of granting CEOs stock options is two-fold:
First, by making them a shareholder, you align their incentives with those of actual shareholders; in a meaningful material way (as opposed to "supposed to" theoretical way the preceding opening paragraph posits).
In other words, if there is an action that a CEO could take to benefit himself as an employee; at the expense of shareholders, they might be tempted to take it - especially if the benefit exceeds their expected future earnings as CEO.
If a large portion of CEO's wealth/income is dependent on being a shareholder, on the other hand, they are less likely to be incentivised to do so.
Second, by offering stock options (which can't be sold immediately), the CEO is further - theoretically - incentivised to behave in a way which ensures that the company's shares - and presumably company's well-being - is well long term, as the options can't be exercised until later.
Hall's results suggest that stock option holdings provide about twice the pay-to-performance sensitivity of stock. This means that if CEO stock holdings were replaced with the same ex ante value of stock options, the pay-to-performance sensitivity for the typical CEO would approximately double. ("Executive Stock Options" from NBER)
Before you raise the issue of "if that's what's supposed to happen, how come CEOs are paid so much yet performance is so meh", that's because they are actually far less stock-invested now than before. According to 1990 Harvard Business Review article "CEO Incentives—It’s Not How Much You Pay, But How
":
With respect to pay for performance, CEO compensation is getting worse rather than better. The most powerful link between shareholder wealth and executive wealth is direct stock ownership by the CEO. Yet CEO stock ownership for large public companies (measured as a percentage of total shares outstanding) was ten times greater in the 1930s than in the 1980s. Even over the last 15 years, CEO holdings as a percentage of corporate value have declined.
This article studied effects of company performance on CEO's wealth and concluded two things:
First, that current (past 15 years regression) situation reflects far too little effect of changes in shareholder value on CEO wealth, in either positive OR negative way.
All told, for the median executive in this sub-sample, a $1,000 change in corporate performance translates into a $2.59 change in CEO wealth.
Second, the best remedy is to increase the % of outstanding shares owned by CEO.
CEOs should own substantial amounts of company stock. The most powerful link between shareholder wealth and executive wealth is direct ownership of shares by the CEO. Most commentators look at CEO stock ownership from one of two perspectives—the dollar value of the CEO’s holdings or the value of his shares as a percentage of his annual cash compensation. But when trying to understand the incentive consequences of stock ownership, neither of these measures counts for much. What really matters is the percentage of the company’s outstanding shares the CEO owns. By controlling a meaningful percentage of total corporate equity, senior managers experience a direct and powerful “feedback effect” from changes in market value.
Lest this be mistaken for "well it should be this way" theoretical economics excercise, the article backs it up with actual figures:
Moreover, these differences in CEO compensation are associated with substantial differences in corporate performance. From 1970 through 1988, the average annual compound stock return on the 25 companies with the best CEO incentives (out of the largest 250 companies examined in our survey) was 14.5%, more than one-third higher than the average return on the 25 companies with the worst CEO incentives. A $100 investment in the top 25 companies in 1970 would have grown to $1,310 by 1988, as compared with $702 for a similar investment in the bottom 25 companies.
Having said that, stock options are rapidly falling out of favor due to having major downsides compared to other forms of stock incentives such as restricted stock grants, due to downsides they offer:
This HBSM article "DO EXECUTIVE STOCK OPTIONS ENCOURAGE RISK-TAKING?" finds that
There is a statistically significant relationship between increases in option holdings by executives and subsequent increases in firm risk.
However, the estimated effect on risk-taking is small and we do not find a negative (or positive) market response to option-induced risk-taking. In sum, although options appear to increase firm risk, there is no evidence that this effect is either large or damaging to shareholders.
Stock options have a downside of incentivising over-aggressiveness and risk taking, e.g. see this UND study which has flaws but is still interesting which found correlation with product recalls.
Stock options specifically lead to reckless behavior when the stock price is low enough that the options are out of the money. This McKinsey paper "Getting what you pay for with stock options" discusses the issue; as well as some other downsides of stock options and mitigation strategies.
