Compensation structure and portfolio selection in a banking firm

Guy Ford

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Abstract

This paper examines how the structural form of a bank's compensation payment function may impact on incentive-compatibility conditions between the centre of the bank (principal) and managers in the bank (agents). If this payment function is asymmetrical, with bonuses paid only upon the realisation of gains, then the ranking of prospective investment portfolios by managers will be influenced by both the distribution of gains in the numerator and the distribution of losses in the denominator of the risk-adjusted performance measure (RAMP). If the distribution of gains is uneven, then it may not be possible to determine which portfolios managers will select without specific knowledge of their utility functions. If the centre is charged with managing both risk and return, as opposed to only managing downside risk, then the RAMP upon which managers are renumerated should incorporate the preferences of the centre with respect to right tail of the distribution of returns in the investment portfolios available to the bank. A reward to risk ratio, where the numenator measures upper partial moments in the distribution of returns, allows portfolios to be ranked in accordance with the attitude of the centre towards variability in upside returns.
Original languageEnglish
Pages (from-to)27-42
Number of pages16
JournalJournal of applied research in accounting and finance
Volume3
Issue number2
Publication statusPublished - 2008

Bibliographical note

Publisher version archived with the permission of the publisher Macquarie Graduate School of Management, Macquarie University, NSW, Australia. This archived copy is available for individual, non-commercial use. Permission to use this version for other uses must be obtained from the publisher.

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