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Competition for traders and risk

Author

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  • Bijlsma, Michiel
  • Boone, Jan
  • Zwart, Gijsbert

Abstract

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.

Suggested Citation

  • Bijlsma, Michiel & Boone, Jan & Zwart, Gijsbert, 2012. "Competition for traders and risk," CEPR Discussion Papers 8816, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:8816
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    References listed on IDEAS

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    1. Besley, Timothy J. & Ghatak, Maitreesh, 2011. "Taxation and Regulation of Bonus Pay," CEPR Discussion Papers 8532, C.E.P.R. Discussion Papers.
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    3. 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.
    4. Palomino, Frederic & Prat, Andrea, 2003. " Risk Taking and Optimal Contracts for Money Managers," RAND Journal of Economics, The RAND Corporation, vol. 34(1), pages 113-137, Spring.
    5. Jonathan B. Berk & Richard C. Green, 2004. "Mutual Fund Flows and Performance in Rational Markets," Journal of Political Economy, University of Chicago Press, vol. 112(6), pages 1269-1295, December.
    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. John Thanassoulis, 2011. "Bankers' Pay Structure And Risk," Economics Series Working Papers 545, University of Oxford, Department of Economics.
    8. 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.
    9. John Thanassoulis, 2011. "The Case For Intervening In Bankers' Pay," Economics Series Working Papers 532, University of Oxford, Department of Economics.
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    Cited by:

    1. Jen-Wen Chang & Simpson Zhang, 2018. "Competitive Pay and Excessive Manager Risk-taking," Working Papers 18-02, Office of Financial Research, US Department of the Treasury.
    2. Efing, Matthias & Hau, Harald & Kampkötter, Patrick & Steinbrecher, Johannes, 2015. "Incentive pay and bank risk-taking: Evidence from Austrian, German, and Swiss banks," Journal of International Economics, Elsevier, vol. 96(S1), pages 123-140.
    3. Roland Bénabou & Jean Tirole, 2016. "Bonus Culture: Competitive Pay, Screening, and Multitasking," Journal of Political Economy, University of Chicago Press, vol. 124(2), pages 305-370.
    4. repec:eee:jaecon:v:64:y:2017:i:1:p:1-14 is not listed on IDEAS
    5. Boustanifar, Hamid & Grant, Everett & Reshef, Ariell, 2016. "Wages and human capital in finance: international evidence, 1970-2005," Globalization and Monetary Policy Institute Working Paper 266, Federal Reserve Bank of Dallas.
    6. John Thanassoulis, 2011. "The Case For Intervening In Bankers' Pay," Economics Series Working Papers 532, University of Oxford, Department of Economics.

    More about this item

    Keywords

    financial institutions; imperfect competition; optimal contracts; remuneration policy; risk;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • L22 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Organization and Market Structure

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