Excessive Risk Taking, Compensation Schemes and Financial Market Stability

Project Start: 01/2014
Status: Completed
Researchers: Sascha Baghestanian, Paul Gortner, Baptiste Massenot
Category: Corporate Finance

Topic and Objectives

The recent financial crisis highlighted the importance of compensation schemes for excessive risk taking in the financial industry. To foster financial stability, a number of reforms have been discussed. Bonus caps have received the most attention and are now being implemented in the European Union. Another suggestion is to give bankers more “skin in the game” by making them liable for losses.

In an experimental setting in which investors can entrust their money to traders, we investigate how traders’ compensation schemes affect liquidity provision and asset prices (SAFE Working Paper No. 108). Traders can trade assets that yield dividends and, thus, potentially high returns. As a consequence, investors can chose between entrusting their money to a trader – with the prospect of high returns but also the risk of dealing with an untrustworthy trader – and keeping their money and receiving a safe but low return.

We study how investors solve this trade-off against the background of different compensation schemes for traders. First, we vary the extent to which traders are liable for losses. Limited liability together with profit sharing creates a conflict of interest between the trader and the investor. Since traders have no downside risk, they highly value assets and are willing to buy them at a high price. On the contrary, investors suffer all the losses while they share the gains. Since they anticipate that traders are ready to invest more than they themselves, they restrict liquidity provision to bring prices more in line with their preferences. As a consequence, limited liability should lead to either higher asset prices or lower liquidity provision.

Second, we study the effect of capping gains. A cap generates a different type of conflict of interest by reducing the potential gains for the trader while increasing those for the investor. Thus, assets become less valuable to traders which can decrease the pressure on prices. At the same time, assets become more valuable to investors incentivizing them to provide more liquidity. As a consequence, caps can have the desired effect of reducing risk taking by traders, but, at the same time, a higher liquidity could increase the pressure on prices.

Key Findings

  • Unexpectedly, liquidity provision is lowest when traders are liable for losses and higher in the presence of a cap and/or limited liability. This implies that investors fail to discipline traders in the presence of limited liability. Also, the cap seems to improve liquidity provision by making the asset more valuable to investors.
  • Asset prices are closer to the fundamental value when traders are liable for losses than under limited liability. This suggests that, as expected, traders take an excessive risk when they are not liable for losses.
  • An inflow of liquidity is positively correlated with the development of asset prices.
  • The introduction of a cap does not have any major impact on asset prices. If anything, the cap seems to slightly increase prices in the presence of unlimited liability.

Policy Implications

Bonus caps do not seem to have an impact on the creation of bubbles. If anything, they foster bubbles by increasing liquidity provision. Making traders liable for losses seems more effective in reducing asset price bubbles. These results stand in stark contrast to the reforms currently being implemented which mostly focus on capping bonuses.

Related Published Papers

Author/s Title Year Research Area Keywords
Sascha Baghestanian, Todd B. Walker Anchoring in Experimental Asset Markets
Journal of Economic Behavior & Organization
2015 Corporate Finance Experimental Asset Markets, Anchoring, Bubbles
Sascha Baghestanian, Paul Gortner, Baptiste Massenot Compensation Schemes, Liquidity Provision, and Asset Prices: An Experimental Analysis
Experimental Economics
2017 Corporate Finance compensation, liquidity, experimental asset markets, bubbles

Related Working Papers

No. Author/s Title Year Research Area Keywords
54 Sascha Baghestanian, Todd B. Walker Anchoring in Experimental Asset Markets 2014 Corporate Finance Experimental Asset Markets, Anchoring, Bubbles
108 Sascha Baghestanian, Paul Gortner, Baptiste Massenot Compensation Schemes, Liquidity Provision, and Asset Prices: An Experimental Analysis 2015 Corporate Finance compensation, liquidity, experimental asset markets, bubbles

 

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