Competition for Traders and Risk

TILEC Discussion Paper No. 2012-003

CentER Discussion Paper Series No. 2012-008

23 Pages Posted: 24 Jan 2012  

Michiel J. Bijlsma

CPB Netherlands Bureau of Economic Policy Analysis; Tilburg Law and Economics Center (TILEC)

Jan Boone

Tilburg University - Center for Economic Research (CentER); Centre for Economic Policy Research (CEPR); TILEC

Gijsbert Zwart

University of Groningen

Multiple version iconThere are 2 versions of this paper

Date Written: January 16, 2012

Abstract

The financial crisis has been attributed partly to perverse incentives for traders at banks and has led policy makers to propose regulation of banks’ remuneration packages. We explain why poor incentives for traders cannot be fully resolved by only regulating the bank’s top executives, and why direct intervention in trader compensation is called for. We present a model with both trader moral hazard and adverse selection on trader abilities. We demonstrate that as competition on the labor market for traders intensifies, banks optimally offer top traders contracts inducing them to take more risk, even if banks fully internalize the costs of negative outcomes. In this way, banks can reduce the surplus they have to offer to lower ability traders. In addition, we find that increasing banks’ capital requirements does not unambiguously lead to reduced risk-taking by their top traders.

Keywords: optimal contracts, remuneration policy, imperfect competition, financial institutions

JEL Classification: G21, G32, L22

Suggested Citation

Bijlsma, Michiel J. and Boone, Jan and Zwart, Gijsbert, Competition for Traders and Risk (January 16, 2012). CentER Discussion Paper Series No. 2012-008. Available at SSRN: https://ssrn.com/abstract=1991136 or http://dx.doi.org/10.2139/ssrn.1991136

Michiel J. Bijlsma (Contact Author)

CPB Netherlands Bureau of Economic Policy Analysis ( email )

P.O. Box 80510
2508 GM The Hague, 2585 JR
Netherlands

Tilburg Law and Economics Center (TILEC)

Warandelaan 2
Tilburg, 5000 LE
Netherlands

Jan Boone

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 2399 (Phone)
+31 13 466 3042 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

TILEC ( email )

Warandelaan 2
Tilburg, 5000 LE
Netherlands

Gijsbert Zwart

University of Groningen ( email )

P.O. Box 800
9700 AH Groningen, Groningen 9700 AV
Netherlands

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