Agency Cost Determinants of Bank Risk-Taking

Kinda Hachem

No 1293, 2014 Meeting Papers from Society for Economic Dynamics

Abstract: This paper studies risk-taking when loan officer compensation is optimally structured to generate competition. Compensation contracts are necessary because bank managers must incentivize officers to screen borrowers and charge type-contingent loan rates. Optimality of a relative performance contract then arises because the bank is imperfectly informed about the quality of the borrower pool from which officers draw. If even good borrowers are slightly risky, I find that the optimal contract can be implemented as a rank-order tournament which compels loan officers to minimize risk-taking across the board. Otherwise, rank-order tournaments are not optimal and a bank which restricts attention to them will find selected risk-taking less costly to incentivize when moderately pessimistic about the borrower pool. Therefore, if the fixed cost of changing compensation structures is high, transitioning from a world without riskless assets to a world with riskless assets can actually increase risk-taking and create more dispersion in the output of bank-dependent borrowers.

Date: 2014
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed014:1293

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