Incentive Pay and Systemic Risk

Rui Albuquerque, Luis Cabral and Jose Guedes

No 11693, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We show that, in the presence of correlated investment opportunities across firms, risk sharing between firm shareholders and firm managers leads to compensation contracts that include relative performance evaluation. These contracts bias investment choices towards correlated investment opportunities, thus creating systemic risk. Furthermore, we show that leverage amplifies all such effects. In the context of the banking industry, we analyze recent policy recommendations regarding firm managerial pay and show how shareholders optimally undo the policies' intended effects.

Date: 2016-12
New Economics Papers: this item is included in nep-ban and nep-cta
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Journal Article: Incentive Pay and Systemic Risk (2019)
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