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Banker Compensation, Relative Performance, and Bank Risk

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  • Arantxa Jarque
  • Edward Simpson Prescott

Abstract

A multi-agent, moral-hazard model of a bank operating under deposit insurance and limited liability is used to analyze the connection between compensation of bank employees (below CEO) and bank risk. Limited liability with deposit insurance is a force that distorts effort down. However, the need to increase compensation to risk-averse employees in order to compensate them for extra bank risk is a force that reduces this effect. Optimal contracts use relative performance and are implementable as a wage with bonuses tied to individual and firm performance. The connection between pay for performance and bank risk depends on correlation of returns. If employee returns are uncorrelated, the form of pay is irrelevant for risk. If returns are perfectly correlated, a low wage can indicate risk. Connections to compensation regulation and characteristics of organizations are discussed.

Suggested Citation

  • Arantxa Jarque & Edward Simpson Prescott, 2019. "Banker Compensation, Relative Performance, and Bank Risk," Working Papers 19-20, Federal Reserve Bank of Cleveland.
    • Handle: RePEc:fip:fedcwq:192000
    DOI: 10.26509/frbc-wp-201920
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    More about this item

    Keywords

    bank regulation; relative performance; incentive compensation;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

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