Relative Performance, Banker Compensation, and Systemic Risk

This paper shows that in the presence of correlated investment opportunities across banks, risk sharing between bank shareholders and bank managers leads to compensation contracts that include relative performance evaluation and to investment decisions that are biased toward such correlated opportunities, thus creating systemic risk. We analyze various policy recommendations regarding bank managerial pay and show that shareholders optimally undo the intended risk-reducing effects of the policies, demonstrating their ineffectiveness in curbing systemic risk. Albuquerque: Associate Professor of Finance, Boston College Carroll School of Management; Research Associate, ECGI; and Research Fellow, CEPR; [email protected]. Cabral: Paganelli-Bull Professor of Economics and International Business, Stern School of Business, New York University; and Research Fellow, CEPR; [email protected]. Guedes: Professor of Finance, Católica Lisbon School of Business and Economics; [email protected] For useful comments and suggestions, we thank Viral Acharya, Anat Admati, David Dicks, Alex Edmans, Fabio Feriozzi, Angela Maddaloni, Nadya Malenko, Kathy Yuan; and seminar participants at Boston College (Finance), Boston College (Economics), HEC Montreal, the 8th European Banking Center Network Conference at Tilburg University, LBS, and the 25th International Rome Conference on Money, Banking and Finance. The usual disclaimer applies. Albuquerque thanks the support from funding grant PTDC/IIM-FIN/2977/2014 of the Portuguese Foundation for Science and Technology-FCT.