Working Papers

We develop a two-period model of incentive provision based on Hopenhayn andJarque (2010). We study the deferral of pay in the optimal contract that implementsprudent risk-taking and discuss implications for the regulation of real-life compensationinstruments, such as bonuses or clawbacks, in the banking sector. In this model, theeffects of hidden actions are persistent and hence are revealed over time. We show that,due to the positive effect of persistence on the information available to the principal, ahigher intensity of persistence (more influence of the effort on the second period results)will sometimes translate into less deferral of pay (less expected pay in the second periodthan in the first). We also compare this model with a standard repeated moral hazard,in which the effects of effort do not persist over time. We find that persistence doesnot necessarily imply a higher proportion of deferred pay.

This paper is a substantial rewrite of the original Working Paper No. 10-16 in the Richmond Fed working paper series, available here.