DP8816 Competition for traders and risk

Author(s): Michiel Bijlsma, Jan Boone, Gijsbert Zwart
Publication Date: February 2012
Keyword(s): financial institutions, imperfect competition, optimal contracts, remuneration policy, risk
JEL(s): G21, G32, L22
Programme Areas: Financial Economics, Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8816

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.