Incentive-compatible compensation and regulation |
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Authors: | An Chen |
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Institution: | 1. Netspar and Faculty of Mathematics and Economics, University of Ulm, 89069 Ulm, Germanyan.chen@uni-ulm.de |
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Abstract: | This article uses contingent claims analysis and regulatory constraints to show how a bank can create incentive-compatible compensation for the senior management aligned with the interests of the 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 the senior management. This prevents unlimited risk taking. Additionally, a maximum regulatory default probability also constrains risk-taking behaviour. We show under which parameterizations the remuneration package and the regulatory constraint offer equal incentives for the senior management. |
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Keywords: | executive stock option programmes call spread default probability regulation |
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