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An Optimal Incentive Contract Preventing Excessive Risk-Taking by a Bank Manager

14 Pages Posted: 3 May 2012  

Henry Penikas

National Research University Higher School of Economics

Date Written: April 27, 2012

Abstract

The Basel Committee of Banking Supervision initiated a discussion on the most efficient practices to prevent bank managers from excessive risk-taking. This paper proposes a game-theoretical approach, describing the decision-making process by a bank manager who chooses his own level of risk and effort. If the level of risk implies the variability of the future outcome, the amount of effort applied affects the probability of a positive outcome. Although effort is unobserved for the bank’s stakeholders, the risk level is under control, and is associated with certain indicators such as capital adequacy ratio or leverage level. The risk-neutral utility function of a bank manager and a binary game outcome of gaining profit or loss for a bank are assumed. Starting from the general incentive contract scheme having the fixed and variable parts of remuneration, it is proposed, that differentiating the variable part of remuneration is sufficient to motivate bank managers to make fewer risky decisions. More precisely, the variable part of remuneration (e.g. the share of the bank’s profit) needs to be higher in proportion to the higher variance of outcome for the high -risk outcome case to stimulate a bank manager to opt for lower-risk decisions in place of higher-risk situations.

Keywords: bank, contract, manager, game-theoretic approach, remuneration

JEL Classification: C70, D86, E58

Suggested Citation

Penikas, Henry, An Optimal Incentive Contract Preventing Excessive Risk-Taking by a Bank Manager (April 27, 2012). Higher School of Economics Research Paper No. WP BRP 03/FE/2012. Available at SSRN: https://ssrn.com/abstract=2049870 or http://dx.doi.org/10.2139/ssrn.2049870

Henry Penikas (Contact Author)

National Research University Higher School of Economics ( email )

Myasnitskaya street, 20
Moscow, Moscow 119017
Russia

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