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Competition for traders and risk

  • Michiel Bijlsma

    ()

  • Gijsbert Zwart

    ()

  • Jan Boone

The financial crisis has been attributed partly to perverse incentives for traders at banks and has led policy makers to propose regulation of banks' remuneration packages. We explain why poor incentives for traders cannot be fully resolved by only regulating the bank's top executives, and why direct intervention in trader compensation is called for. We present a model with both trader moral hazard and adverse selection on trader abilities. We demonstrate that as competition on the labour market for traders intensifies, banks optimally offer top traders contracts inducing them to take more risk, even if banks fully internalize the costs of negative outcomes. In this way, banks can reduce the surplus they have to offer to lower ability traders. In addition, we find that increasing banks' capital requirements does not unambiguously lead to reduced risk-taking by their top traders.

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Paper provided by CPB Netherlands Bureau for Economic Policy Analysis in its series CPB Discussion Paper with number 204.

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Date of creation: Feb 2012
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Handle: RePEc:cpb:discus:204
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  1. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  2. Timothy Besley & Maitreesh Ghatak, 2011. "Taxation and regulation of bonus pay," LSE Research Online Documents on Economics 58192, London School of Economics and Political Science, LSE Library.
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  4. Jonathan B. Berk & Richard C. Green, 2002. "Mutual Fund Flows and Performance in Rational Markets," FAME Research Paper Series rp100, International Center for Financial Asset Management and Engineering.
  5. John Thanassoulis, 2011. "The Case For Intervening In Bankers' Pay," Economics Series Working Papers 532, University of Oxford, Department of Economics.
  6. Hellwig, Martin F., 2009. "A reconsideration of the Jensen-Meckling model of outside finance," Journal of Financial Intermediation, Elsevier, vol. 18(4), pages 495-525, October.
  7. Bruno Biais & Catherine Casamatta, 1999. "Optimal Leverage and Aggregate Investment," Journal of Finance, American Finance Association, vol. 54(4), pages 1291-1323, 08.
  8. John Thanassoulis, 2011. "Bankers' Pay Structure And Risk," Economics Series Working Papers 545, University of Oxford, Department of Economics.
  9. Kashyap, Anil K. & Rajan, Raghuram G. & Stein, Jeremy C., 2008. "Rethinking capital regulation," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 431-471.
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