Relative Performance, Banker Compensation, and Systemic Risk
47 Pages Posted: 20 Nov 2016 Last revised: 25 May 2017
Date Written: May 23, 2017
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