Working Paper: CEPR ID: DP8816
Authors: Michiel Bijlsma; Jan Boone; Gijsbert Zwart
Abstract: The financial crisis has been attributed partly to perverse incentives for traders at banks and has led policy makers to propose regulation of banks' remuneration packages. We explain why poor incentives for traders cannot be fully resolved by only regulating the bank's top executives, and why direct intervention in trader compensation is called for. We present a model with both trader moral hazard and adverse selection on trader abilities. We demonstrate that as competition on the labour market for traders intensifies, banks optimally offer top traders contracts inducing them to take more risk, even if banks fully internalize the costs of negative outcomes. In this way, banks can reduce the surplus they have to offer to lower ability traders. In addition, we find that increasing banks' capital requirements does not unambiguously lead to reduced risk-taking by their top traders.
Keywords: financial institutions; imperfect competition; optimal contracts; remuneration policy; risk
JEL Codes: G21; G32; L22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increased competition for traders (D41) | higher risk-taking by top traders (G41) |
| banks' capital requirements (G21) | risk-taking behavior of traders (G41) |
| Increased competition for traders (D41) | banks offering contracts that induce top traders to take on more risk (G21) |
| increased banks' capital requirements (G28) | greater risk-taking among top traders (G41) |