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The Owner-Manager Conflict in Insured Banks: Predetermined Salary vs. Bonus Payments

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  • Ben Z. Schreiber
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    Abstract

    This paper examines the incentive of a bank's owners and manager to increase the level of assets risk if bank deposits are insured. The model consists of three players: a public insurer (e.g., the FDIC), the bank's owners (owners), and its manager (manager). Empirical evidence has shown that the management of risk (e.g., credit and interest risk) and a low level of audit and control can be instrumental in causing banks to fail or get into financial difficulties. In the model presented here, the form of compensation to the manager plays a crucial role in determining the level of asset risk. We show under which conditions and form of compensation bank's owners and manager have an incentive to raise the risk level. The model is run first under the assumption that the information between the bank and the insurer is symmetrical, and then under the assumption that it is asymmetrical for two forms of pay: a predetermined salary, and bonus payments whose value is not known at the time the contract between the owners and the manager is signed. We also examine whether there is a pareto-optimal contract between the owners and the manager as regards the risk level, given the two forms of pay. This question is important because the absence of such a contract could indicate the existence of a source of instability in the banking system. This paper was presented at the Financial Institutions Center's October 1996 conference on "

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    Bibliographic Info

    Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 96-38.

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    Date of creation: Oct 1996
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    Handle: RePEc:wop:pennin:96-38

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    1. Landskroner, Yoram & Paroush, Jacob, 1994. "Deposit insurance pricing and social welfare," Journal of Banking & Finance, Elsevier, vol. 18(3), pages 531-552, May.
    2. Agrawal, Anup & Mandelker, Gershon N, 1987. " Managerial Incentives and Corporate Investment and Financing Decision s," Journal of Finance, American Finance Association, vol. 42(4), pages 823-37, September.
    3. Marcus, Alan J & Shaked, Israel, 1984. "The Valuation of FDIC Deposit Insurance Using Option-pricing Estimates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 16(4), pages 446-60, November.
    4. John, Kose & John, Teresa A. & Senbet, Lemma W., 1991. "Risk-shifting incentives of depository institutions: A new perspective on federal deposit insurance reform," Journal of Banking & Finance, Elsevier, vol. 15(4-5), pages 895-915, September.
    5. Greenwald, Bruce C & Stiglitz, Joseph E, 1986. "Externalities in Economies with Imperfect Information and Incomplete Markets," The Quarterly Journal of Economics, MIT Press, vol. 101(2), pages 229-64, May.
    6. Crawford, Anthony J & Ezzell, John R & Miles, James A, 1995. "Bank CEO Pay-Performance Relations and the Effects of Deregulation," The Journal of Business, University of Chicago Press, vol. 68(2), pages 231-56, April.
    7. Mark D. Flood, 1990. "On the use of option pricing models to analyze deposit insurance," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 19-35.
    8. Flannery, Mark J., 1991. "Pricing deposit insurance when the insurer measures bank risk with error," Journal of Banking & Finance, Elsevier, vol. 15(4-5), pages 975-998, September.
    9. Stephen F. LeRoy, 1990. "Mutual deposit insurance," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue jun8.
    10. Berlin, Mitchell & Saunders, Anthony & Udell, Gregory F., 1991. "Deposit insurance reform: What are the issues and what needs to be fixed?," Journal of Banking & Finance, Elsevier, vol. 15(4-5), pages 735-752, September.
    11. Kane, Edward J., 1986. "Appearance and reality in deposit insurance: The case for reform," Journal of Banking & Finance, Elsevier, vol. 10(2), pages 175-188, June.
    12. Goldberg, Lawrence G & Harikumar, T, 1991. "Risk-Taking Incentives of Banks and Risk-Adjusted Deposit Insurance," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 14(3), pages 233-39, Fall.
    13. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    14. Acharya, Sankarshan & Dreyfus, Jean-Francois, 1989. " Optimal Bank Reorganization Policies and the Pricing of Federal Deposit Insurance," Journal of Finance, American Finance Association, vol. 44(5), pages 1313-33, December.
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