Competition, Bonuses, and Risk-Taking in the Banking Industry

Abstract

Remuneration systems in the banking industry, particularly bonus payments, have frequently been blamed for contributing to the build-up of risks leading to the recent financial crisis. In our model banks compete for managerial talent that is private information. Competition for talent sets incentives to offer bonuses inducing risk-taking that is excessive not only from society's perspective, but also from the viewpoint of the banks themselves. In fact, bonus payments and excessive risk-taking are increasing with competition. Thus, our model offers a rationale why bonuses are paid even when reducing the expected profits of banks. This confirms the impact of competitive pressures on the remuneration schemes as claimed by many industry representatives and assigns a positive role to legal restrictions on bonus payments.

Keywords: Bonuses, excessive risk, screening, competition

JEL Classification: D86, J31, J33