Incentive Compensation for Risk Managers When Effort Is Unobservable

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