Incentives, Risk and Compensation Schemes: Experimental Evidence on the Importance of Risk Adequate Compensation

Compensation schemes have been blamed for encouraging excess risk-taking on the part of managers within the financial system and real economy. In general, compensation cannot decrease below the base salary, while gains from bonuses can be limitless. The potential link between compensation and risk behavior is analyzed in this paper. A behavioral experiment with students shows that unilaterally constructed incentive schemes encourage excess risk-taking. Thus common bonus-based compensation schemes are badly constructed and risk enhancing. Unilaterally constructed compensation schemes were one reason for the financial crisis.