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Incentive compensation in the banking industry: insights from economic theory

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  • Douglas Clement
  • Christopher Phelan

Abstract

How can banks and similar institutions design optimal compensation systems? Would such systems conflict with the goals of society? This paper considers a theoretical framework of how banks structure job contracts with their employees to explore three points: the structure of a socially optimal compensation system; the structure of a compensation system that is privately optimal, given the reality of government-guaranteed bank debt; and policy interventions that can lead from the second structure to the first. Analysis reveals a potential policy option: providing proper incentives to banks by charging debt default insurance premiums that depend on the compensation structure banks choose. If policymakers consider this unwise or impractical, then it may be useful for government to regulate bank compensation more directly.

Suggested Citation

  • Douglas Clement & Christopher Phelan, 2009. "Incentive compensation in the banking industry: insights from economic theory," Economic Policy Paper 09-1, Federal Reserve Bank of Minneapolis.
    • Handle: RePEc:fip:fedmep:09-1
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    Citations

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    Cited by:

    1. Feldman, Ron J. & Stern, Gary H., 2010. "The Squam Lake Report: Observations from two policy professionals," Journal of Monetary Economics, Elsevier, vol. 57(7), pages 903-912, October.
    2. Borys Grochulski, 2011. "Financial firm resolution policy as a time-consistency problem," Economic Quarterly, Federal Reserve Bank of Richmond, vol. 97(2Q), pages 133-152.
    3. Jarque, Arantxa & Prescott, Edward Simpson, 2020. "Banker compensation, relative performance, and bank risk," Journal of the Japanese and International Economies, Elsevier, vol. 56(C).

    More about this item

    Keywords

    Incentive awards; Executives - Salaries;

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