Banker Compensation and Bank Risk Taking: The Organizational Economics View

30 Pages Posted: 6 Mar 2013

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: March 4, 2013

Abstract

Models of banks operating under limited liability with deposit insurance and employee incentive problems are used to analyze how banker compensation contracts can contribute to bank risk shifting. The first model is a multi-agent, moral-hazard model, where each agent (e.g. a loan officer) operates a risky lending technology. Results differ from the single-agent model; pay for performance contracts do not necessarily indicate risk at the bank level. Correlation of returns is the most important factor. If loan officer returns are uncorrelated, the form of pay is irrelevant for risk. If returns are correlated, a low wage causes risk. If correlation is endogenous, relative performance contracts that encourage correlation of returns can create bank risk. A sufficient condition for a contract to induce risk at the bank level is provided. The second model adds a loan review and risk management function that affects risk characteristics of loan officers' loans. Counter to common perception, paying loan reviewers and risk managers for performance does not necessarily create risk. The model also identifies the importance of evaluating the quality of bank controls as a means for limiting bank risk.

Keywords: incentive compensation, bank regulation, risk shifting

JEL Classification: D82, G21, G28, J33

Suggested Citation

Jarque, Arantxa and Prescott, Edward (Ned) Simpson, Banker Compensation and Bank Risk Taking: The Organizational Economics View (March 4, 2013). FRB Richmond Working Paper No. 13-03. Available at SSRN: https://ssrn.com/abstract=2228910 or http://dx.doi.org/10.2139/ssrn.2228910

Arantxa Jarque

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

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

Edward (Ned) Simpson Prescott (Contact Author)

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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