The Owner-Manager Conflict in Insured Banks: Predetermined Salary vs. Bonus Payments

This paper examines the incentive of a bank's owners and manager to increase the level of assets risk if bank deposits are insured. The model consists of three players: a public insurer (e.g., the FDIC), the bank's owners (owners), and its manager (manager). Empirical evidence has shown that the management of risk (e.g., credit and interest risk) and a low level of audit and control can be instrumental in causing banks to fail or get into financial difficulties. In the model presented here, the form of compensation to the manager plays a crucial role in determining the level of asset risk. We show under which conditions and form of compensation bank's owners and manager have an incentive to raise the risk level. The model is run first under the assumption that the information between the bank and the insurer is symmetrical, and then under the assumption that it is asymmetrical for two forms of pay: a predetermined salary, and bonus payments whose value is not known at the time the contract between the owners and the manager is signed. We also examine whether there is a pareto-optimal contract between the owners and the manager as regards the risk level, given the two forms of pay. This question is important because the absence of such a contract could indicate the existence of a source of instability in the banking system. This paper was presented at the Financial Institutions Center's October 1996 conference on "