Competition for Traders and Risk
CentER Discussion Paper Series No. 2012-008
23 Pages Posted: 24 Jan 2012
Date Written: January 16, 2012
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 labor 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: optimal contracts, remuneration policy, imperfect competition, financial institutions
JEL Classification: G21, G32, L22
Suggested Citation: Suggested Citation