Incentive Contracts and Risk Taking in Financial Institutions

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Little is known about finance professionals' compensation schemes or how these schemes vary with performance. We aim to help narrow this gap with our current project by analyzing individual's compensation data and investment. Our aim is twofold: First, to document existing incentive contracts for market operators employed in financial institutions and second, to analyse the effect these contracts have on employee decisions, particularly the degree of risk they take on. In order to answer these questio ns, we need access to individual's exact contracts, investment mandates, trading histories, investment performance and personal rewards over a long period. We also need access to employees' group and divisional remuneration policies, and internal bonus gu idelines. Four Norwegian Financial Institutions have confirmed that they will support our project with the relevant data for as long a time period and in as much detail as available. We will have to hand-collect the aforementioned data at the various f inancial institutions due to heterogeneity in reporting formats between institutions. We will also have access to an annual survey on compensation practices in the Norwegian financial services industry that is run by Mercer. We will focus our analysis on mid-level agents. There are two key rationales for doing so. The first is that risk taking behaviour at this level can lead to substantial risk exposure of the institution as a whole, as the recent US$2 billion trading loss at JP Morgan highlights. The s econd is that it is relatively straightforward to associate incentive schemes to the risk taking behaviour of these agents, since the outcomes of their decisions can be associated with standard market measures of risk and return.