Relative Performance, Banker Compensation, and Systemic Risk
This recent paper by Rui Albuquerque (Boston College), Luis Cabral (NYU) and Jose Correa Guedes (Catholic University of Portugal) 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.
The paper analyzes 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.