Banker compensation and bank risk taking: the organizational economics view
AbstractModels of banks operating under limited liability with deposit insurance and employee incentive problems are used to analyze how banker compensation contracts can contribute to bank risk shifting. The first model is a multi-agent, moral-hazard model, where each agent (e.g. a loan officer) operates a risky lending technology. Results differ from the single-agent model; pay for performance contracts do not necessarily indicate risk at the bank level. Correlation of returns is the most important factor. If loan officer returns are uncorrelated, the form of pay is irrelevant for risk. If returns are correlated, a low wage causes risk. If correlation is endogenous, relative performance contracts that encourage correlation of returns can create bank risk. A sufficient condition for a contract to induce risk at the bank level is provided. The second model adds a loan review and risk management function that affects risk characteristics of loan officers' loans. Counter to common perception, paying loan reviewers and risk managers for performance does not necessarily create risk. The model also identifies the importance of evaluating the quality of bank controls as a means for limiting bank risk.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 13-03.
Date of creation: 2013
Date of revision:
This paper has been announced in the following NEP Reports:
- NEP-ALL-2013-04-13 (All new papers)
- NEP-BAN-2013-04-13 (Banking)
- NEP-CTA-2013-04-13 (Contract Theory & Applications)
- NEP-HRM-2013-04-13 (Human Capital & Human Resource Management)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Ing-Haw Cheng & Harrison Hong & Jose A. Scheinkman, 2010.
"Yesterday's Heroes: Compensation and Creative Risk-Taking,"
NBER Working Papers
16176, National Bureau of Economic Research, Inc.
- Ing-Haw Cheng & Harrison Hong & Jose Scheinkman, 2010. "Yesterday’s Heroes: Compensation and Creative Risk-Taking," NBER Chapters, in: Market Institutions and Financial Market Risk National Bureau of Economic Research, Inc.
- Marshall, David A. & Prescott, Edward Simpson, 2001.
"Bank capital regulation with and without state-contingent penalties,"
Carnegie-Rochester Conference Series on Public Policy,
Elsevier, vol. 54(1), pages 139-184, June.
- David A. Marshall & Edward S. Prescott, 2000. "Bank capital regulation with and without state-contingent penalties," Working Paper Series WP-00-10, Federal Reserve Bank of Chicago.
- Edward Simpson Prescott, 2004.
"State-contingent bank regulation with unobserved actions and unobserved characteristics,"
04-02, Federal Reserve Bank of Richmond.
- Marshall, David A. & Prescott, Edward Simpson, 2006. "State-contingent bank regulation with unobserved actions and unobserved characteristics," Journal of Economic Dynamics and Control, Elsevier, vol. 30(11), pages 2015-2049, November.
- David A. Marshall & Edward Simpson Prescott, 2004. "State-Contingent Bank Regulation With Unobserved Actionas And Unobserved Characteristics," Working Papers wp2004_0407, CEMFI.
- David A. Marshall & Edward Simpson Prescott, 2002. "State-contingent bank regulation with unobserved action and unobserved characteristics," Working Paper Series WP-02-24, Federal Reserve Bank of Chicago.
- Patrick Bolton & Hamid Mehran & Joel Shapiro, 2010. "Executive compensation and risk taking," Staff Reports 456, Federal Reserve Bank of New York.
- Keeley, Michael C. & Furlong, Frederick T., 1990. "A reexamination of mean-variance analysis of bank capital regulation," Journal of Banking & Finance, Elsevier, vol. 14(1), pages 69-84, March.
- Edward Simpson Prescott & Arantxa Jarque, 2011.
"Optimal bonuses and deferred pay for bank employees: implications of hidden actions with persistent effects in time,"
2011 Meeting Papers
1230, Society for Economic Dynamics.
- Arantxa Jarque & Edward S. Prescott, 2010. "Optimal bonuses and deferred pay for bank employees : implications of hidden actions with persistent effects in time," Working Paper 10-16, Federal Reserve Bank of Richmond.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (William Perkins).
If references are entirely missing, you can add them using this form.