Dynamic Innovation of Incentives, Risk Management and Banking Performance: State-owned Commercial Banks in China

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1 Dynamic Innovaion of Incnivs, isk Managmn an Banking Prformanc: a-own Commrcial Banks in China Huang Yingli Qiao Yu Qiu Zhaown 3 chool of Economics an Managmn, Norh-as Forsry Univrsiy, Harbin, China,50040 Dparmn of Economics, Univrsiy of urry, urry, UK, GU 7XH 3 Insiu of Informaion an Compur Enginring, Norhas Forsry Univrsiy, Harbin, P..China,50040 ( Yinglihuang336@yahoo.com, y.qiao@surry.ac.uk, qiuzw@yahoo.cn Absrac Effciv incniv an isciplin mchanism ac an imporan rol in commrcial banks govrnanc. W sign a wo-prio ynamic agn mol wih asymmric informaion o highligh h rlaionship bwn Cnral AFE Invsmn Co., (AFE an h managr of sa-own banks. W assum hr ar wo yps of risk managmn: asy an ifficul. Th managr woul hav four sragis o choos. Our rsuls focus on boh paris' quilibrium args. Comparisons bwn rminisic nvironmn an sochasic sing ar also rla. Th rsuls also suggs h rach ffc occurs ovrim unr asy yp an AFE has wo conflicing incnivs whn signing conrac. Ky wors sa-own commrcial banks, ynamic Innovaion, risk managmn Inroucion Th banking scor is so imporanc o h counry s conomy. Th govrnmn hn launch svral rforms o spark a raical urnaroun in h Big Four []. Th framwork of corpora govrnanc in banking scor has xis, vn so, much work rmains o b on []. cn xprinc in boh China an ohr conomis in ransiion inica ha corporaion os no guaran ha profssional, rahr han poliical managrs will b appoin [3]. Thrfor, w focus on xamining h ynamic incnivs, risk managmn an banking prformanc. Thr ar hr inrsing qusions involv in banking managrs conracs. Firs, wha kin of incniv schm can shor-rm conracs provi? con, how os h rach ffc affc h banking managrs ffor an risk managmn coss of banking cass? An hir, wha is h rol ha h uncrainy posiion chang plays? In on wor, h rlaionship bwn AFE an h banking managr is h ky. Our rsuls focus on boh paris' quilibrium args. Comparisons bwn rminisic nvironmn an sochasic sing ar also rla. Th rsuls also suggs h rach ffc occurs ovrim unr asy yp an AFE has wo conflicing incnivs whn signing conrac. Th papr is ivi ino four pars. Nx scion vlops a wo-prio sochasic ynamic mol. Afr ha, scion hr, h main par of h papr, sparaing quilibriums an smi-sparaing quilibriums ar follow-on. Th final par summarizs our conclusions an givs som oulooks for fuur rsarch. Th Two-prio Mol In his scion, w analyz h rlaionship bwn h AFE an banking managr in banking managmn cass in a wo-prio mol. W also assum ha for h sam banking managr h ifficuly of h cas os no chang in any cour lvl. W fin banking managmn cass only hav wo yps for h banking managr: h asy yp an h ifficul yp. Whn haning in a cas, a banking managr woul hav four sragis. Firs, if h cas is asy yp, h can rpor i honsly. con, if h cas is asy yp, h banking managr can xaggra h ifficuly an hrfor g mor pay from h ockholrs. Thir, if h cas is ifficul yp, h banking managr rpors h ifficuly ruhfully. Fourh, if h cas is ifficul yp, h banking managr may lighn h ifficuly. Th las sragy is a lil bi ifficul o b unrsoo. If h banking managr os so, h will los a par of pay in his cas. Bu whn w consir h rpuaion incniv, h banking managr may boas 953

2 his abiliy an hnc gain mor offrs from clins. hock rm will b inrouc o xplain uncrainy in h cas.. Th Two-Prio Basic Mol unr Prfc Informaion Consir a wo-prio banking managmn cas. Assum ha conracs ar shor-rm an sign a bginning of ach prio. Th AFE has no nough powr o commi o fuur conracs. Tha is a ncssary coniion for h rach ffc o b a concrn. Morovr, risk managmn cos is affc by unobsrvabl nois, as is in h gnral mol of Jischko al (00. In prio, ( =, a hir banking managr rpors o h AFE h risk managmn risk managmn coss involv in running h cas. Th risk managmn cos is: c = β, =, Each prio h banking managr s pay is U = s (, whr s is h n monary ransfr h rcivs from h AFE an ψ ( is his isuiliy of ffor ( ψ '( > 0, ψ ''( > 0. No ha boh h AFE an h banking managr ar risk-nural. Th social prformanc is fin as following: W = D + U ( + λ [ c + s ] whr D is h valu of h cas. Th AFE sks o maximiz xpc financial safy an banking prformanc. Unr prfc informaion ( β = β = β, ach prio, h AFE woul solv: { D + U ( + λ [ c s ]} W = max + s, = s s.. U ψ ( 0 Th iniviual raionaliy consrain U = s ( 0 implis ha h uiliy lvl of h banking managr mus b nough o paricipa. Th opimal soluion is characriz by s = ψ, =, whr ψ '( =. ( Thus, unr prfc informaion h ffor of h banking managr is opimal an h marginal isuiliy of ffor is qua o marginal risk managmn cos saving [4].. Two-Prio Conracs unr Asymmric Informaion In his scion, w apply our basic mol o a wo-prio, wo-yp asymmric informaion cas. Th rach ffc canno b avoi sinc w suppos ha h AFE canno commi o a wo prio conrac. Th squnc of vns for h gam is givn by: (Th banking managr simas h cas (afr simaion h knows h xac lvl of h ifficuly of h cas an rpors h cas s ifficuly, which has wo valus β an β ( 0 < β < β, o h AFE. (Accoring o h risk managmn cos funcion c = β, h mor ifficul h cas, h mor risk managmn cosly h cas. (Bas upon h banking managr s rpor h AFE offrs a conrac ha consiss of an incniv schul s ( c. Th banking managr ihr accps h conrac or rjcs i. If h rjcs h conrac h will rciv his rsrvaion uiliy of 0 an h rlaionship is issolv. (3If h banking managr accps h conrac, in h firs-prio, h paricipas in h cas; h ranom shock ε an hnc h risk managmn cos c ar raliz an obsrv by AFE. (4Th AFE upas hr blifs an offrs a scon-prio conrac. In nw conrac, h AFE may iscoun h xpc monary ransfr. Th banking managr ihr accps h nw conrac or rjcs i. W sar wih h scon-prio conrac. Th conracs offr by h AFE mus saisfy iniviual raionaliy an incniv compaibiliy consrains for ach yp. I : s ( 0, I : s ( 0, 954

3 IC : s ψ ( s (, IC : s ψ ( s ( Incniv compaibiliy implis h conrac sign for h yp h on prfrr by h yp. Iniviual raionaliy nsurs h paricipaion of banking managr [5]. Th quilibriums in which h banking managr civs shoul b consir. Typ I: IC an I bin an h banking managr may aggraniz h ifficuly of h asy cas wih probabiliy x. Typ II: IC an I bin an h banking managr may lighn h ifficuly of h ifficul cas wih probabiliy y. Typ III: IC, IC an I bin an h banking managr may ihr aggraniz (h asy cas or lighn (h ifficul on h ifficuly of h cas. In h siuaion of h cas is ifficul an h banking managr may lighn h ifficul (Typ II, i is obvious ha if his happns h pay of h banking managr crass. Typ II canno b opimal for h AFE for h cas whr α =. Hnc w concnra on quilibrium of Typ I an Typ III in his papr. In h rs of his papr w choos isuiliy of banking managr as a quaraic, α ψ ( = [ max(,0 ]. For simpliciy, w assum α = an η > c c (hr is a no larning zon. 3 mi-sparaing Equilibriums W now allow for h possibiliy ha h banking managr chas in h firs prio; in paricular, h rpors β, h cas s ru ifficuly, wih probabiliy x [ 0,]. Accoringly, h AFE upas hr ρ( x blif in h scon prio, so hr posrior blif ha h cas is asy yp is: ρ = ρ ρx In h sochasic sing, h acual risk managmn cos obsrv by h AFE is subjc o nois. Thus, rgarlss of h banking managr s sragis, h AFE migh no obsrv risk managmn coss iffrn o hos associa wih h sragis. As w iscuss bfor, h probabiliy of obsrving a rvaling risk managmn cos of h asy cas (xcluing h banking managr s sragis for a momn is θ, which is fin as: + θ = Pr( c < c η = Pr( c < c + η = η imilarly, h probabiliy of a non-rvaling risk managmn cos is η ( + θ = η Thrfor, h xpc Prio prformanc is givn by: AI AI EW = ρ x θ W + ( θ W ( ρ + ( ρ x θ W ( ρ This xprssion is bas upon ha h AFE s blifs o no chang in scon prio if sh can obsrv h non-rvaling risk managmn cos, whil sh can upa hr blifs if c > c + η. In h firs prio, hr ar hr possibiliis:th cas is asy yp, an h banking managr rpors ruhfully, wih probabiliy ρ x, ha yils prformanc: W = pd ( p( + λ ( C + β λ s. 955

4 Th cas is asy yp, h banking managr chas, wih probabiliy ρ ( x, ha yils ( prformanc: W = pd ( p( + λ( C + β λ s.in h siuaion of h cas is ifficul yp, wih probabiliy ρ. Th banking managr ruhfully rpors h ifficuly, prformanc is: W = pd ( p( + λ ( C + β λ s. In prio, h xpc prformanc is givn by EW = ρ x W + ρ ( x W + ( ρ W. Th rlvan consrains ar β s iniviual raionaliy consrain ( I an β s incniv compaibiliy consrain ( IC. olv h AFE s problm in smi-sparaing quilibrium: max EW = EW + EW, Hnc, h AFE ajuss h banking managr s ffor lvl for h asy cas rlaiv o ha man in h sparaing quilibrium. Th sign of his ajusmn is rmin by : whn his is posiiv.this is inrsing sinc, as w hav sn, a rlaivly long-sigh AFE ( > is rquir for xprimnaion whn x = (sul. As xprimnaion involvs wining h ffor gap, h scon ffc w hav now iscovr rucs his ffc on β ' s ffor lvl whn x <. Combining his obsrvaion wih sul, w hav Lmma : In a smi-sparaing Typ I quilibrium, a ncssary coniion for o incras in h sochasic cas, rlaiv o h rminisic on, is < <. Ψ Lmma : In a smi-sparaing Typ I quilibrium, a ncssary coniion for o incras in h sochasic cas, rlaiv o h rminisic on, is < <. Ψ 4 Conclusions an Oulook Th conclusions can b ivi by wo siuaions. Firs, h cas is an asy yp. I is obvious ha in his siuaion h banking managr can incras his profi hrough xaggraing h cas s ifficuly. Th prformanc analysis brings wo inrsing rsuls. Th formr is ha whn h AFE an h banking managr iscoun fuur a sam ra, h AFE has o incras h asy cas s risk managmn cos an ruc h ifficul cas s risk managmn cos. By his way, h AFE ncourags banking managr rpor ruhfully. In fac, as a AFE, h AFE has mor concrns abou fuur. This givs h lar rsul: Whn h iscoun facors ar iffrn an h AFE iscouns fuur havily, h asy cas s risk managmn cos is ruc an h ifficul cas s risk managmn cos is incras. Th conflic of hs wo rsuls implis a ilmma: Th AFE givs lss fuur pay o inify h ifficuly of h cas, bu his acion xacrbas h rach ffc. Th banking managr hrfor has mor incnivs o cha. If h banking managr can cha in h firs prio, h AFE ajuss h banking managr s ffor lvls, wih rspc o h ifficuly of h cas, rlaiv o ha man in h sparaing quilibrium. 956

5 con, h banking managr may cha whavr h cas s yp. This is h siuaion ha h banking managr may ihr xaggra or lighn h ifficuly of h cas. As w iscuss, his is possibl bcaus, u o rpuaion incniv, h banking managr may boas his abiliy an hnc lighns h cas s ifficuly. Thr ar hr rsuls o mphasiz. Firs, non-xprimnaion occurs whn h probabiliy ha h banking managr lighns h ifficuly is biggr han h probabiliy of aggranizing h ifficuly. con, whn h banking managr s iscoun ra riss, i os no affc whhr xprimnaion aks plac, bu i os affc h xn of xprimnaion or non-xprimnaion. Thir, h AFE s iscoun ra now plays no rol in whhr xprimnaion aks plac. ummarily, in his siuaion, h AFE s concrn abou h fuur os no affc args of h banking managr. Th rach ffc occurs an if h banking managr has goo firs prio prformancs h will hav incras xpcaions of pay. In aiion, h sa-own banks mus b commrcializ o mak profi-sking hir primary rason for xisnc. Enir nw mchanisms mus b pu in plac o nsur ha poliical figurs ar supplan by profssional managrs in ky posiions [6]. Finally, propr inrnal incnivs ha basic salaris on mark ras an inclu prformanc incnivs mus b pu in plac. Acknowlgmns This rsarch was suppor by h China Posocoral cinc Founaion (h firs gr rwar unr Gran an also suppor by h Minisry of ucaion of h Popl s public of Founaion unr Gran 06JC frncs [] Chn Xubin. An Analysis on Compnsaional Incnivs of Commrcial Banks of China. Journal of Financ, 005(7: 3-6. In Chins [] Chn Xubin, Zhang Wn.Th Improvmn of h Chins Commrcial Bank s Inniv an Disciplin Mchanism. Journal of Inrnaional Financ, 003(3: 7-. In Chins [3] Aams an Mhran. Is corpora govrnanc iffrn for bank holing companis?. Fral srv Bank of Nw York Working Paprs, 003. [4] Casas-Arc, P.; Marónz-Jrz, F. laiv prformanc compnsaion, conxs an ynamic incnivs. Working papr, Harvar Univrsiy, 005. [5] Charls Halock, Jol Houson an Michal yngar. Th ol of Managrial Incnivs in Bank Acquisiions. Amrican Economic viw, 999(6: [6] Cor, Guay an Larckr. Excuiv Equiy Compnsaion an Incnivs: A urvy, Fral srv Bank of Nw York Economic Policy viw, 003, l(9: