Compensation Structure and Portfolio Selection in a Banking Firm

Abstract

This paper examines how the structural form of a bank's compensation payment function may impact on incentive-compatibility conditions between the centre of the bank (principal) and managers in the bank (agents). If this payment function is asymmetrical, with bonuses paid only upon the realisation of gains, then the ranking of prospective investment portfolios by managers will be influenced by both the distribution of gains in the numerator and the distribution of losses in the denominator of the risk-adjusted performance measure (RAMP). If the distribution of gains is uneven, then it may not be possible to determine which portfolios managers will select without specific knowledge of their utility functions. If the centre is charged with managing both risk and return, as opposed to only managing downside risk, then the RAMP upon which managers are renumerated should incorporate the preferences of the centre with respect to right tail of the distribution of returns in the investment portfolios available to the bank. A reward to risk ratio, where the numenator measures upper partial moments in the distribution of returns, allows portfolios to be ranked in accordance with the attitude of the centre towards variability in upside returns.

Keywords: Compensation, portfolio selection, RAMP

JEL Classification: G20, G21, J33, G34