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An Optimal Incentive Contract Preventing Excessive Risk-Taking by a Bank Manager

Author

Listed:
  • Henry Penikas

    (International Laboratory for of Decision Choice and Analysis of the National Research University Higher School of Economics;)

Abstract
The Basel Committee of Banking Supervision initiated a discussion on the most efficient practices to prevent bank managers from excessive risk-taking. This paper proposes a game-theoretical approach, describing the decision-making process by a bank manager who chooses his own level of risk and effort. If the level of risk implies the variability of the future outcome, the amount of effort applied affects the probability of a positive outcome. Although effort is unobserved for the bank’s stakeholders, the risk level is under control, and is associated with certain indicators such as capital adequacy ratio or leverage level. The risk-neutral utility function of a bank manager and a binary game outcome of gaining profit or loss for a bank are assumed. Starting from the general incentive contract scheme having the fixed and variable parts of remuneration, it is proposed, that differentiating the variable part of remuneration is sufficient to motivate bank managers to make fewer risky decisions. More precisely, the variable part of remuneration (e.g. the share of the bank’s profit) needs to be higher in proportion to the higher variance of outcome for the high -risk outcome case to stimulate a bank manager to opt for lower-risk decisions in place of higher-risk situations

Suggested Citation

  • Henry Penikas, 2012. "An Optimal Incentive Contract Preventing Excessive Risk-Taking by a Bank Manager," HSE Working papers WP BRP 03/FE/2012, National Research University Higher School of Economics.
    • Handle: RePEc:hig:wpaper:03/fe/2012
    as

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    File URL: http://www.hse.ru/data/2012/05/02/1250601225/03FE2012.pdf
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    References listed on IDEAS

    as
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    bank; contract; manager; game-theoretic approach; remuneration.;
    All these keywords.

    JEL classification:

    • C70 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - General
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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