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The Limits to Compensation in the Financial Sector

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  • H Peyton Young
  • Thomas Noe

Abstract

In recent years bonuses tied to performance have become commonplace in banks and other financial institutions; indeed they now constitute a major part of employee compensation. The practice was originally justified by academic work on principal-agent contracts, which argued that performance bonuses would better align the interests of managers and shareholders. In this article we argue that such schemes are not well-suited to aligning these interests in the financial sector. There are two reasons for this failure. First, new financial products make it easy to create the appearance of superior performance over long periods of time even though the outsize returns are merely being driven by hidden tail risk. We show that it is virtually impossible to create performance contracts that get around this problem. Second, the complexity of new products and the size of modern financial institutions make it extremely difficult (and costly) to monitor risky activities directly. As in the first case, compensation schemes, including deferred compensation, are inefficient substitutes because it is easy to escape detection for long periods of time. This opens the door for outright fraud. We argue that a greater emphasis on ethical values, e.g., a duty of care to customers and shareholders, is more likely to produce effective reforms.

Suggested Citation

  • H Peyton Young & Thomas Noe, 2012. "The Limits to Compensation in the Financial Sector," Economics Series Working Papers 635, University of Oxford, Department of Economics.
  • Handle: RePEc:oxf:wpaper:635
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    File URL: http://www.economics.ox.ac.uk/materials/papers/12477/paper635.pdf
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    References listed on IDEAS

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    1. Dean P. Foster & H. Peyton Young, 2010. "Gaming Performance Fees By Portfolio Managers," The Quarterly Journal of Economics, Oxford University Press, vol. 125(4), pages 1435-1458.
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    Cited by:

    1. Kozubovska, Mariolia, 2017. "The effect of US bank holding companies’ exposure to asset-backed commercial paper conduits on the information opacity and systemic risk," Research in International Business and Finance, Elsevier, vol. 39(PA), pages 530-545.
    2. Francesco Feri, Caterina Giannetti, Pietro Guarnieri, 2017. "Risk taking for others: an experiment on ethics meetings," Discussion Papers 2017/229, Dipartimento di Economia e Management (DEM), University of Pisa, Pisa, Italy.

    More about this item

    Keywords

    Performance bonus; incentive contract; tail risk;

    JEL classification:

    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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