Banker Compensation, Relative Performance, and Bank Risk

35 Pages Posted: 13 Nov 2019

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: November 05, 2019

Abstract

A multi-agent, moral-hazard model of a bank operating under deposit insurance and limited liability is used to analyze the connection between compensation of bank employees (below CEO) and bank risk. Limited liability with deposit insurance is a force that distorts effort down. However, the need to increase compensation to risk-averse employees in order to compensate them for extra bank risk is a force that reduces this effect. Optimal contracts use relative performance and are implementable as a wage with bonuses tied to individual and firm performance. The connection between pay for performance and bank risk depends on correlation of returns. If employee returns are uncorrelated, the form of pay is irrelevant for risk. If returns are perfectly correlated, a low wage can indicate risk. Connections to compensation regulation and characteristics of organizations are discussed.

Keywords: incentive compensation, relative performance, bank regulation

JEL Classification: D82, G21, G28, J33

Suggested Citation

Jarque, Arantxa and Prescott, Edward (Ned) Simpson, Banker Compensation, Relative Performance, and Bank Risk (November 05, 2019). FRB of Cleveland Working Paper No. 19-20. Available at SSRN: https://ssrn.com/abstract=3485742 or http://dx.doi.org/10.2139/ssrn.3485742

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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