Banks Incentive Pay, Diversification and Systemic Risk

This paper analyzes the effects of bank manager’s incentive pay on financial stability. Two banks are owned by risk-neutral principals and run by risk-averse managers that determine the level of leverage and how much to diversify into the other bank’s asset. Diversification and leverage in turn determine both idiosyncratic and systemic insolvency risk. We first characterize the optimal incentive pay contract under the assumption that a planner maximizes the total value of the banks. The optimal contract features both absolute and relative performance evaluation, and it pins down the optimal diversification and leverage. In equilibrium, even if the principal represents the interests of all stakeholders of an individual bank, the contract relies too much on relative performance evaluation, which induces an inefficiently high level of diversification, leverage, and systemic risk. We show that regulations on managerial pay in place may increase systemic risk and only regulating the relative performance evaluation restores efficiency