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Incentive-compatible compensation and regulation

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  • An Chen

Abstract

This article uses contingent claims analysis and regulatory constraints to show how a bank can create incentive-compatible compensation for the senior management aligned with the interests of the other stakeholders. For this purpose, the remuneration package takes the form of a 'call spread' on the bank's equity. Unlike regular stock option programmes, a call spread limits the upside potential for the senior management. This prevents unlimited risk taking. Additionally, a maximum regulatory default probability also constrains risk-taking behaviour. We show under which parameterizations the remuneration package and the regulatory constraint offer equal incentives for the senior management.

Suggested Citation

  • An Chen, 2014. "Incentive-compatible compensation and regulation," Applied Economics, Taylor & Francis Journals, vol. 46(25), pages 3074-3081, September.
    • Handle: RePEc:taf:applec:v:46:y:2014:i:25:p:3074-3081
    DOI: 10.1080/00036846.2014.922671
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