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Capital FailureRebuilding Trust in Financial Services$
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Nicholas Morris and David Vines

Print publication date: 2014

Print ISBN-13: 9780198712220

Published to Oxford Scholarship Online: October 2014

DOI: 10.1093/acprof:oso/9780198712220.001.0001

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The Limits to Compensation in the Financial Sector

The Limits to Compensation in the Financial Sector

(p.65) 3 The Limits to Compensation in the Financial Sector
Capital Failure

Thomas Noe

H. Peyton Young

Oxford University Press

Performance bonuses have become commonplace in financial institutions and now constitute a major part of employee compensation. Such practice followed academic work on principal-agent contracts, which argued that bonuses would better align the interests of managers and shareholders. This chapter argues that such schemes are not well-suited to aligning these interests for two reasons. First, new financial products make it easy to create the appearance of superior performance over long periods of time, with the outsize returns driven by hidden tail risk. Second, the complexity of new products and the size of financial institutions make it extremely difficult (and costly) to monitor risky activities directly. Compensation schemes are inefficient because it is easy to escape detection for long periods of time. A greater emphasis on ethical values, reflecting duty of care to customers, clients, and shareholders, is more likely to produce effective reforms.

Keywords:   incentives, performance bonuses, principal agent, fat tail risks, risk management, incentive compensation

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