Relative Performance, Banker Compensation, and Systemic Risk
50 Pages Posted: 20 Nov 2016 Last revised: 7 Jan 2018
Date Written: January 1, 2018
We show that, in the presence of correlated investment opportunities across banks, risk sharing between bank shareholders and bank managers leads to (a) compensation contracts that include relative performance evaluation; and (b) investment decisions that are biased toward such correlated opportunities, thus creating systemic risk. We analyze various policy recommendations regarding bank managerial pay and show how shareholders optimally undo the policies’ intended risk-reducing effects. We discuss alternative measures that can effectively decrease the systemic risk arising from pay packages.
Keywords: Systemic risk, bank regulation, relative performance evaluation, optimal contracts
JEL Classification: G01, G21, G28
Suggested Citation: Suggested Citation