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Working Paper

Banker Compensation, Relative Performance, and Bank Risk

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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.
Topics
Bank policy and regulation
11.05.2019ISSN 2573-7953 WP 19-20DOI 10.26509/frbc-wp-201920
Keywords incentive compensation, relative performance, bank regulation
JEL Classification Codes D82, G21, G28, J33

Working Papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded official Federal Reserve Bank of Cleveland publications. The views expressed in this paper are those of the authors and do not represent the views of the Federal Reserve Bank of Cleveland or the Federal Reserve System.

Suggested Citation

Prescott, Edward S., and Arantxa Jarque. 2019. “Banker Compensation, Relative Performance, and Bank Risk.” Federal Reserve Bank of Cleveland, Working Paper No. 19-20. https://doi.org/10.26509/frbc-wp-201920