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Competition for traders and risk

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  • Bijlsma, Michiel
  • Boone, Jan
  • Zwart, Gijsbert

Abstract

The financial crisis has been attributed partly to perverse incentives for traders at banks and has led policy makers to propose regulation of banks' remuneration packages. We explain why poor incentives for traders cannot be fully resolved by only regulating the bank's top executives, and why direct intervention in trader compensation is called for. We present a model with both trader moral hazard and adverse selection on trader abilities. We demonstrate that as competition on the labour market for traders intensifies, banks optimally offer top traders contracts inducing them to take more risk, even if banks fully internalize the costs of negative outcomes. In this way, banks can reduce the surplus they have to offer to lower ability traders. In addition, we find that increasing banks' capital requirements does not unambiguously lead to reduced risk-taking by their top traders.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8816.

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Date of creation: Feb 2012
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Handle: RePEc:cpr:ceprdp:8816

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Keywords: financial institutions; imperfect competition; optimal contracts; remuneration policy; risk;

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  1. Palomino, Frédéric & Prat, Andrea, 1999. "Risk Taking and Optimal Contracts for Money Managers," CEPR Discussion Papers 2066, C.E.P.R. Discussion Papers.
  2. Jonathan B. Berk & Richard C. Green, 2002. "Mutual Fund Flows and Performance in Rational Markets," NBER Working Papers 9275, National Bureau of Economic Research, Inc.
  3. John Thanassoulis, 2011. "Bankers' Pay Structure And Risk," Economics Series Working Papers 545, University of Oxford, Department of Economics.
  4. John Thanassoulis, 2011. "The Case For Intervening In Bankers' Pay," Economics Series Working Papers 532, University of Oxford, Department of Economics.
  5. Bruno Biais & Catherine Casamatta, 1999. "Optimal Leverage and Aggregate Investment," Journal of Finance, American Finance Association, vol. 54(4), pages 1291-1323, 08.
  6. Kashyap, Anil K. & Rajan, Raghuram G. & Stein, Jeremy C., 2008. "Rethinking capital regulation," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 431-471.
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Cited by:
  1. John Thanassoulis, 2011. "The Case For Intervening In Bankers' Pay," Economics Series Working Papers 532, University of Oxford, Department of Economics.

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