DP11693 Incentive Pay and Systemic Risk

Author(s): Rui Albuquerque, Luís M B Cabral, José Guedes
Publication Date: December 2016
Date Revised: May 2018
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Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11693

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.