Competition for traders and risk
| Author | Gijsbert Zwart,Michiel Bijlsma,Jan Boone |
| DOI | http://doi.org/10.1111/1756-2171.12254 |
| Date | 01 December 2018 |
| Published date | 01 December 2018 |
RAND Journal of Economics
Vol.49, No. 4, Winter 2018
pp. 855–876
Competition for traders and risk
Michiel Bijlsma∗
Jan Boone∗∗
and
Gijsbert Zwart∗∗∗
Perverse incentives for banks’ traders have played a role in the financial crisis. We study how
labor market competition interacts with the structure of compensation to result in excessive
risk taking. In a model with trader moral hazard and adverse selection on trader abilities, we
demonstrate how banks optimally induce top tradersto take more risk as competition on the labor
market intensifies, even if banks internalize the costs of negative outcomes. Distortingrisk-taking
incentives allows banks to reduce the surplus offeredto low-ability traders. We find that increasing
bank capital requirements does not unambiguously reduce risk taking by top traders.
1. Introduction
The financial crisis has been attributed partly to perverse incentives for traders at banks. High
bonuses for above-averageperformance drove traders to engage in riskier trading strategies. Short-
term trading gains which in reality were compensation for high downside risk were disguised as
profits resulting from above average trader abilities, so it has been argued.1
Why did banks offer huge bonuses, inducing their traders to take excessiverisk? Clearly, one
explanation is that banks simply did not internalize the negative effectsof risk, being protected by
implicit bailout guarantees. In this article, we explore another channel: the role of competition on
the labor market for traders in shaping risk-taking incentives from trader bonuses. This analysis is
inspired by claims that, even with value-maximizing bank managers, trader compensation could
be excessively high powered as a result of strong competition among banks in hiring top traders.2
∗Tilburg University, and Netherlands Bureau for Economic Policy Analysis, CPB; m.j.bijlsma@cpb.nl.
∗∗Tilburg University, and Netherlands Bureau for Economic Policy AnalysisCPB, and CEPR; j.boone@uvt.nl.
∗∗∗University of Groningen; g.t.j.zwart@rug.nl.
We benefited from participants’ comments at EARIE 2010, Infiniti 2011, internal seminars at Tilec and CPB, as well
as from suggestions by Arnoud Boot, Andrei Dubovik, Martin Hellwig, Martin Peitz, three anonymous referees, and
the Editor, David Martimort. We thank Fleur van den Bosch for excellent research assistance in the initial stages of
this project. Boone gratefully acknowledges financial support from the Netherlands Organisation for Scientific Research
(NWO) through a Vici grant.
1See, for instance, Kashyap, Rajan, and Stein (2008) and Clementi et al. (2009).
2Kashyap, Rajan, and Stein (2008) claim that “Retaining top traders, given the competition for talent, requires
that they be paid generously based on performance.” Clementi et al. (2009) argue for closer cooperation among banks in
C2018 The Authors. The RAND Journal of Economics published by Wiley Periodicals, Inc. on behalf of The RAND
Corporation.
This is an open access article under the terms of the Creative Commons Attribution-NonCommercial License, which
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856 / THE RAND JOURNAL OF ECONOMICS
Anecdotal evidence of such competition abounds. In April 2010, Kaspar Villiger, chairman of
the Swiss bank UBS, defended the firm’sgenerous pay plans to angry shareholders by saying that
an earlier move to cut compensation had backfired. When an entire team of 60 employees had
left UBS investment bank’s equities unit, he said, “We cut back too much last year, causing us
to lose entire teams, their clients and the corresponding revenue.”3When Warren Buffet stepped
in at Salomon Brothers in the 1990s after the firm had gotten into trouble, he tried to realign
perverse compensation practices. This resulted in defections of top bankers, and eventually a
reversal of the reforms. In his statement for the Financial Crisis Inquiry Commission in 2010,
Buffett remarked: “I can just tell you, being at Salomon personally, it’s just, it’s a real problem
because the fellow can go next door or he can set up a hedge fund or whatever it may be. You
don’t, you don’t have a good way of having some guy that produces x dollars of revenues to give
him 10% of x because he’ll figure out, he’ll find some other place that will give him 20% of x or
whatever it maybe.” In an ar ticle in the FinancialTimes, a banker is quoted saying, “The bonuses
are crazy—we all know that. But wedon’t know how to stop paying them without losing our best
staff” (Tett, 2009).
The idea, however, raises an immediate question. It is clear that increased competition for
traders raises their expected remuneration. Indeed, such an effect has been found empirically for
Chief Executive Officer (CEO) compensation by Bereskin and Cicero (2013), who study a pool
of firms competing for the same talent, of which a subset receives a governance shock affecting
compensation level. However, it is less clear why the need to leave a larger part of the rents to
traders should lead to a different incentive structure. Independent of competition, it would seem
that the banks would opt for the incentive structure that leads to highest overall gain, as also
observed in Inderst and Pfeil (2013).
We show that competition does increase the risk induced by traders’ incentive contracts
when there is both trader moral hazard over investment projects and adverse selection on trader
abilities. Boustanifar, Grant, and Reshef (2018) show empirically that wages in the financial
sector have increased in response to deregulation, and that this effect is stronger in environments
where asymmetric information is more severe. Evidence for the fact that traders differ in their
trading skills (and that their trading results are not merely a matter of luck) was provided by, for
instance, Berk and Green (2004). Banks use compensation schemes both to incentivize traders to
choose appropriate investment projects and to attract in particular the top traders. The latter goal
is achieved by increasing rewards for top results, which are more easily achieved by top traders.4
The downside is that this increases risk profiles sought by these top traders. As competition for
top traders increases, the importance of sorting the top traders (and avoiding paying similarly
high compensations to traders of average ability) grows, and so the benefit of increasing bonus
pay over base wage increases, whereas the costs of inducing the traders to take excessive risks
remains unchanged.
We explore this in a model in which two banks compete `
a la Hotelling in hiring traders. We
assume that traders, protected by limited liability, can choose between projects that differ both
in expected return and in risk. We consider two types of traders, top traders and average traders.
Top traders are better at making high-risk investments than average traders in the sense that their
expected payout for such projects is higher.This allows banks to screen on trader type by offering
top traders contracts that reward them more strongly for high outcomes. Using this idea, wemake
the following points. First,when top traders have sufficiently good outside options, the bank has to
pay these traders high wages. To prevent those high wages from spilling over to average traders,
revising employee remuneration structure: “Giventhe fluid market for financial talent, no single firm can get ver y far on
its own.”
3Financial Times, “Chastened UBS board promises ‘sensitivity,”’ April 14, 2010.
4As a compensation consultant, commenting on moves by traders from banks to less-regulated hedge funds, puts
it, “Your bonus doesn’t fully depend on what your book made, hence the huge amount of turnover, people whose books
are making a lot of money and feel they aren’tbeing compensated f airlymoving to the buy-side, typically hedge funds or
private equity firms” (on news.efinancialcareers.com, August 25, 2017).
C
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