Michiel J. Bijlsma
CPB Netherlands Bureau of Economic Policy Analysis; Tilburg Law and Economics Center (TILEC)

Jan Boone
Tilburg University - Center for Economic Research (CentER); Centre for Economic Policy Research (CEPR); Institute for the Study of Labor (IZA); TILEC

Gijsbert Zwart
CPB Netherlands Bureau of Economic Policy Analysis; Tilburg Law and Economics Center (TILEC)

Abstract

The financial crisis has been attributed partly to perverse incentives for traders at banks and has led policy makers to propose regulation of banks’ remuneration packages. We explain why poor incentives for traders cannot be fully resolved by only regulating the bank’s top executives, and why direct intervention in trader compensation is called for. We present a model with both trader moral hazard and adverse selection on trader abilities. We demonstrate that as competition on the labor market for traders intensifies, banks optimally offer top traders contracts inducing them to take more risk, even if banks fully internalize the costs of negative outcomes. In this way, banks can reduce the surplus they have to offer to lower ability traders. In addition, we find that increasing banks’ capital requirements does not unambiguously lead to reduced risk-taking by their top traders.