THE OWNER-MANAGER CONFLICT IN INSURED BANKS - PREDETERMINED SALARY VERSUS BONUS PAYMENTS

This article examines the incentive of a bank's owners and manager to increase the level of assets risk if bank deposits are insured. The mo del consists of three players: a public insurer (e.g., the FDIC), the bank's owners, and its manager. Empirical evidence has shown that the management of risk (e.g., credit and interest rate risk) and a low lev el of audit and control can be instrumental in causing banks to fail o r get into financial difficulties. In the model, the form of compensat ion to the manager plays a crucial role in determining the level of as set risk. The article shows under which conditions and form of compens ation bank's owners and manager have an incentive to raise the risk le vel. The model is run first under the assumption that the information between the bank and the insurer is symmetrical, and then under the as sumption that it is asymmetrical for two forms of pay: a predetermined salary; and bonus payments whose value is not known at the time the c ontract between the owners and the manager is signed. The article also examines whether there is a Pareto-optimal contract between the owner s and the manager as regards the risk level, given the two forms of pa y. This question is important because the absence of such a contract c ould indicate the existence of a source of instability in the banking system.