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.
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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)
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