Competition for Traders and Risk

M. Bijlsma, J. Boone, Gijsbert Zwart

Research output: Working paperDiscussion paperOther research output

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Abstract

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 labour 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.
Original languageEnglish
Place of PublicationTilburg
PublisherEconomics
Number of pages23
Volume2012-008
Publication statusPublished - 2012

Publication series

NameCentER Discussion Paper
Volume2012-008

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Traders
Incentives
Adverse selection
Surplus
Politicians
Financial crisis
Capital requirements
Bank capital
Moral hazard
Risk taking
Labour market
Remuneration
Costs

Keywords

  • optimal contracts
  • remuneration policy
  • imperfect competition
  • financial institutions
  • risk

Cite this

Bijlsma, M., Boone, J., & Zwart, G. (2012). Competition for Traders and Risk. (CentER Discussion Paper; Vol. 2012-008). Tilburg: Economics.
Bijlsma, M. ; Boone, J. ; Zwart, Gijsbert. / Competition for Traders and Risk. Tilburg : Economics, 2012. (CentER Discussion Paper).
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Bijlsma, M, Boone, J & Zwart, G 2012 'Competition for Traders and Risk' CentER Discussion Paper, vol. 2012-008, Economics, Tilburg.

Competition for Traders and Risk. / Bijlsma, M.; Boone, J.; Zwart, Gijsbert.

Tilburg : Economics, 2012. (CentER Discussion Paper; Vol. 2012-008).

Research output: Working paperDiscussion paperOther research output

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N2 - 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 labour 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.

AB - 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 labour 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.

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KW - imperfect competition

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Bijlsma M, Boone J, Zwart G. Competition for Traders and Risk. Tilburg: Economics. 2012. (CentER Discussion Paper).