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Optimal bonuses and deferred pay for bank employees: implications of hidden actions with persistent effects in time

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  • Edward Simpson Prescott

    (Richmond Fed)

  • Arantxa Jarque

    (Richmond Fed)

Abstract

We present a sequence of two-period models of incentive-based compensation in order to understand how the properties of optimal compensation structures vary with changes in the model environment. Each model corresponds to a different occupation within a bank, such as credit line managers, loan originators, or traders. All models share a common trait: the effects of hidden actions are persistent, and hence are revealed over time. We characterize the corresponding optimal contracts that are consistent with prudent risk taking. We compare the contracts by ranking them according to the average wage, the proportion of deferred compensation, and the structure and importance of variable pay (bonuses). We also compare these characteristics of the models with persistence with those of a standard repeated moral hazard. We find that small changes in the structure of asymmetric information have important implications for the characteristics of optimal pay, and that persistence does not necessarily imply a higher proportion of deferred pay.

Suggested Citation

  • Edward Simpson Prescott & Arantxa Jarque, 2011. "Optimal bonuses and deferred pay for bank employees: implications of hidden actions with persistent effects in time," 2011 Meeting Papers 1230, Society for Economic Dynamics.
  • Handle: RePEc:red:sed011:1230
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    Cited by:

    1. Feess, Eberhard & Wohlschlegel, Ansgar, 2014. "Bank Capital Requirements and Mandatory Deferral of Compensation," MPRA Paper 59456, University Library of Munich, Germany.
    2. Arantxa Jarque & Edward Simpson Prescott, 2013. "Banker compensation and bank risk taking: the organizational economics view," Working Paper 13-03, Federal Reserve Bank of Richmond.
    3. Borys Grochulski, 2011. "Financial firm resolution policy as a time-consistency problem," Economic Quarterly, Federal Reserve Bank of Richmond, issue 2Q, pages 133-152.

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