Banks incentive pay, diversification and systemic risk

Abstract

This paper analyzes the impact of incentive pay for bank managers on financial stability. The study focuses on two banks owned by risk-neutral principals but operated by risk-averse managers who decide on leverage and the extent of diversification into the other bank’s assets, both of which determine the systemic risk. To begin, we establish the optimal incentive pay contract assuming a planner seeks to maximize the total value of the banks. In equilibrium, we find that the contract excessively relies on relative performance evaluation, leading to an inefficiently high degree of diversification, leverage, and systemic risk. This outcome obtains even when the principal represents the interests of all stakeholders in an individual bank. We demonstrate that only regulation specifically targeting relative performance evaluation can restore efficiency, while existing regulations on managerial pay can inadvertently amplify systemic risk.