Incentive Compensation for Risk Managers When Effort is Unobservable

Abstract

In a stylized model of a financial intermediary, risk managers expend costly effort to reduce loan PD and LGD. When effort is unobservable, incentive compensation (IC) can induce manager effort, but underwriting and loss mitigation managers require different IC contracts. Subsidized insured deposit funding decreases the demand for risk management because it decreases the insurance subsidy. When IC is required to induce effort, it further increases the principal’s costs because wages which are subsidized by the insurer are replaced with IC which is not. These additional costs reduce the principal’s demand for risk management and discourage IC contracts. Regulatory policy should reinforce an insured depository’s incentives to offer appropriate risk management IC contracts and yet existing regulatory guidance explicitly discourages performance-linked IC for risk managers.

Keywords: risk management, incentive compensation, regulatory policy, deposit insurance

JEL Classification: G21, G2, G3