Working Paper

Banker Compensation, Relative Performance, and Bank Risk

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: bank regulation; relative performance; incentive compensation;

JEL Classification: D82; G21; G28; J33;

https://doi.org/10.26509/frbc-wp-201920

Bibliographic Information

Provider: Federal Reserve Bank of Cleveland

Part of Series: Working Papers

Publication Date: 2019-11-05

Number: 19-20