Incentive-compatible compensation and regulation

An Chen

Applied Economics, 2014, vol. 46, issue 25, 3074-3081

Abstract: This article uses contingent claims analysis and regulatory constraints to show how a bank can create incentive-compatible compensation for the senior management aligned with the interests of the other stakeholders. For this purpose, the remuneration package takes the form of a 'call spread' on the bank's equity. Unlike regular stock option programmes, a call spread limits the upside potential for the senior management. This prevents unlimited risk taking. Additionally, a maximum regulatory default probability also constrains risk-taking behaviour. We show under which parameterizations the remuneration package and the regulatory constraint offer equal incentives for the senior management.

Date: 2014
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DOI: 10.1080/00036846.2014.922671

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