Optimal Bonuses and Deferred Pay for Bank Employees: Implications of Hidden Actions with Persistent Effects in Time

43 Pages Posted: 16 Dec 2012

See all articles by Arantxa Jarque

Arantxa Jarque

Federal Reserve Banks - Federal Reserve Bank of Richmond

Edward S. Prescott

Federal Reserve Banks - Federal Reserve Bank of Cleveland

Date Written: October 1, 2010

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.

Keywords: moral hazard, persistence, bonus, deferred pay, banking

JEL Classification: D80, D82, D86, G21, G28

Suggested Citation

Jarque, Arantxa and Prescott, Edward (Ned) Simpson, Optimal Bonuses and Deferred Pay for Bank Employees: Implications of Hidden Actions with Persistent Effects in Time (October 1, 2010). FRB Richmond Working Paper No. 10-16. Available at SSRN: https://ssrn.com/abstract=2189547 or http://dx.doi.org/10.2139/ssrn.2189547

Arantxa Jarque (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

Edward (Ned) Simpson Prescott

Federal Reserve Banks - Federal Reserve Bank of Cleveland ( email )

P.O. Box 6387
Cleveland, OH 44101
United States

HOME PAGE: http://https://www.clevelandfed.org/people-search?pid=f8ca941e-4b51-41f6-95f8-c87f1d3806e5

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