Incentive Compatible Compensation and Regulation
23 Pages Posted: 22 Feb 2013 Last revised: 20 May 2014
Date Written: May 19, 2014
Abstract
This paper uses contingent claims analysis and regulatory constraints to show how a bank can create incentive compatible compensation for senior management aligned with the interests of other stakeholders. For this purpose, the remuneration package takes the form of a "call spread'' on the bank's equity. Unlike regular stock option programmes, a call spread limits the upside potential for senior management. This prevents unlimited risk taking. Additionally, a maximum regulatory default probability also constrains risk taking behavior. We show under which parameterizations the remuneration package and the regulatory constraint offer equal incentives for senior management.
Keywords: executive stock option programmes, call spread, default probability, regulation
JEL Classification: G23
Suggested Citation: Suggested Citation
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