Discussion Paper Details

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Title: Incentive Pay and Systemic Risk

Author(s): Rui Albuquerque, Luís M B Cabral and José Guedes

Publication Date: December 2016


Programme Area(s): Financial Economics

Abstract: We show that, in the presence of correlated investment opportunities across firms, risk sharing between firm shareholders and firm managers leads to compensation contracts that include relative performance evaluation. These contracts bias investment choices towards correlated investment opportunities, thus creating systemic risk. Furthermore, we show that leverage amplifies all such effects. In the context of the banking industry, we analyze recent policy recommendations regarding firm managerial pay and show how shareholders optimally undo the policies' intended effects.

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Bibliographic Reference

Albuquerque, R, Cabral, L and Guedes, J. 2016. 'Incentive Pay and Systemic Risk'. London, Centre for Economic Policy Research.