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

Henry Penikas

HSE Working papers from 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

Keywords: bank; contract; manager; game-theoretic approach; remuneration. (search for similar items in EconPapers)
JEL-codes: C70 D86 E58 (search for similar items in EconPapers)
Pages: 14 pages
Date: 2012
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Published in WP BRP Series: Financial Economics / FE, April 2012, pages 1-14

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