Incentive compensation for risk managers when effort is unobservable

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Abstract:

In a stylized model of a financial intermediary, risk managers can expend effort to reduce loan probability of default (PD) and loss given default (LGD), but effort is costly and unobservable. Incentive compensation (IC) can induce manager effort, but underwriting and loss mitigation managers require different IC contracts. When the intermediary uses subsidized insured deposit funding, the demand for risk management declines because effort decreases the insurance subsidy. Consequently, the principal may no longer offer risk manager IC. Regulatory policy should reinforce an insured depository’s incentives to offer risk mangers appropriate IC contracts and yet existing regulatory guidance explicitly prohibits performance-linked IC for risk managers.

 

Incentive Compensation for Risk Managers When Effort is Unobservable by American Enterprise Institute

 

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About the Author

 

Paul H.
Kupiec
  • Paul H. Kupiec is a resident scholar at the American Enterprise Institute (AEI), where he studies systemic risk and the management and regulations of banks and financial markets. He also follows the work of financial regulators such as the Federal Reserve and examines the impact of financial regulations on the US economy.

    Before joining AEI, Kupiec was an associate director of the Division of Insurance and Research within the Center for Financial Research at the Federal Deposit Insurance Corporation (FDIC), where he oversaw research on bank risk measurement and the development of regulatory policies such as Basel III. Kupiec was also director of the Center for Financial Research at the FDIC and chairman of the Research Task Force of the Basel Committee on Banking Supervision. He has previously worked at the International Monetary Fund (IMF), Freddie Mac, J.P. Morgan, and for the Division of Research and Statistics at the Board of Governors of the Federal Reserve System.

    Kupiec has edited many professional journals, including the Journal of Financial Services Research, Journal of Risk, and Journal of Investment Management.

    He has a bachelor of science degree in economics from George Washington University and a doctorate in economics — with a specialization in finance, theory, and econometrics — from the University of Pennsylvania.

  • Phone: 202.862.7167
    Email: paul.kupiec@aei.org
  • Assistant Info

    Name: Brian C. Marein
    Phone: 202.862.5890
    Email: brian.marein@aei.org

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