Incentive Pay and Systemic Risk
48 Pages Posted: 20 Nov 2016 Last revised: 29 Aug 2018
Date Written: August 21, 2018
We show that, in the presence of correlated investment opportunities across firms, risk sharing between firm shareholders and firm managers leads to compensation contracts that include relative performance evaluation. These contracts bias investment choices towards correlated investment opportunities, thus creating systemic risk. Furthermore, we show that leverage amplifies all such effects. In the context of the banking industry, we analyze recent policy recommendations regarding firm managerial pay and show how shareholders optimally undo the policies' intended effects.
Keywords: Systemic risk, bank regulation, relative performance evaluation, optimal contracts
JEL Classification: G01, G21, G28
Suggested Citation: Suggested Citation