Operational Risk Management

Team Based Incentive Bonus and Effort Coupling

Yuqian Xu, Lingjiong Zhu

Research output: Working paper

Abstract

We consider a financial firm that offers bonus to its employees in order to provide incentives to reduce operational risk losses. We characterize the optimal incentive bonus based on a team of employees, and then explore the impact of team characteristics (heterogeneous and homogeneous workforce) and effort coupling (both collaboration and disruption in a team) among team members on the optimal bonus. We first show that if the economies of scale phenomenon exists for the firm's risk reduction function, then an optimal strategy could be to only award one employee in the team. We then discuss when the optimal strategy is to offer bonuses to multiple employees in the team and present the ordering policy of the incentive bonuses. We subsequently extend our main model to characterize the employees' effort coupling effect and show that (i) the firm is more (less) likely to pay out bonuses when there is a positive (negative) coupling effect than when there is no effect; (ii) when the coupling effect between employees is high, either positive or negative, the optimal bonuses are small; (iii) the minimum total expected cost goes down when positive coupling effect increases or negative coupling effect decreases. We conclude with a numerical experiment using operational risk loss data from a commercial bank. The experiments suggest that if our focal bank awards between 7.26% and 48% (depending on the coupling effect) of the annual salaries as bonuses to its employees, then its total expected operational risk losses would be reduced considerably.
Original languageEnglish (US)
Number of pages38
DOIs
StatePublished - Sep 8 2018

Fingerprint

Bonus
Incentives
Employees
Risk management
Operational risk
Bonuses
Optimal strategy
Experiment
Ordering policy
Firm risk
Salary
Economies of scale
Numerical experiment
Risk reduction
Disruption
Costs
Workforce
Commercial banks

Keywords

  • operational risk
  • incentive bonus
  • loss reduction
  • workforce

Cite this

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title = "Operational Risk Management: Team Based Incentive Bonus and Effort Coupling",
abstract = "We consider a financial firm that offers bonus to its employees in order to provide incentives to reduce operational risk losses. We characterize the optimal incentive bonus based on a team of employees, and then explore the impact of team characteristics (heterogeneous and homogeneous workforce) and effort coupling (both collaboration and disruption in a team) among team members on the optimal bonus. We first show that if the economies of scale phenomenon exists for the firm's risk reduction function, then an optimal strategy could be to only award one employee in the team. We then discuss when the optimal strategy is to offer bonuses to multiple employees in the team and present the ordering policy of the incentive bonuses. We subsequently extend our main model to characterize the employees' effort coupling effect and show that (i) the firm is more (less) likely to pay out bonuses when there is a positive (negative) coupling effect than when there is no effect; (ii) when the coupling effect between employees is high, either positive or negative, the optimal bonuses are small; (iii) the minimum total expected cost goes down when positive coupling effect increases or negative coupling effect decreases. We conclude with a numerical experiment using operational risk loss data from a commercial bank. The experiments suggest that if our focal bank awards between 7.26{\%} and 48{\%} (depending on the coupling effect) of the annual salaries as bonuses to its employees, then its total expected operational risk losses would be reduced considerably.",
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author = "Yuqian Xu and Lingjiong Zhu",
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N2 - We consider a financial firm that offers bonus to its employees in order to provide incentives to reduce operational risk losses. We characterize the optimal incentive bonus based on a team of employees, and then explore the impact of team characteristics (heterogeneous and homogeneous workforce) and effort coupling (both collaboration and disruption in a team) among team members on the optimal bonus. We first show that if the economies of scale phenomenon exists for the firm's risk reduction function, then an optimal strategy could be to only award one employee in the team. We then discuss when the optimal strategy is to offer bonuses to multiple employees in the team and present the ordering policy of the incentive bonuses. We subsequently extend our main model to characterize the employees' effort coupling effect and show that (i) the firm is more (less) likely to pay out bonuses when there is a positive (negative) coupling effect than when there is no effect; (ii) when the coupling effect between employees is high, either positive or negative, the optimal bonuses are small; (iii) the minimum total expected cost goes down when positive coupling effect increases or negative coupling effect decreases. We conclude with a numerical experiment using operational risk loss data from a commercial bank. The experiments suggest that if our focal bank awards between 7.26% and 48% (depending on the coupling effect) of the annual salaries as bonuses to its employees, then its total expected operational risk losses would be reduced considerably.

AB - We consider a financial firm that offers bonus to its employees in order to provide incentives to reduce operational risk losses. We characterize the optimal incentive bonus based on a team of employees, and then explore the impact of team characteristics (heterogeneous and homogeneous workforce) and effort coupling (both collaboration and disruption in a team) among team members on the optimal bonus. We first show that if the economies of scale phenomenon exists for the firm's risk reduction function, then an optimal strategy could be to only award one employee in the team. We then discuss when the optimal strategy is to offer bonuses to multiple employees in the team and present the ordering policy of the incentive bonuses. We subsequently extend our main model to characterize the employees' effort coupling effect and show that (i) the firm is more (less) likely to pay out bonuses when there is a positive (negative) coupling effect than when there is no effect; (ii) when the coupling effect between employees is high, either positive or negative, the optimal bonuses are small; (iii) the minimum total expected cost goes down when positive coupling effect increases or negative coupling effect decreases. We conclude with a numerical experiment using operational risk loss data from a commercial bank. The experiments suggest that if our focal bank awards between 7.26% and 48% (depending on the coupling effect) of the annual salaries as bonuses to its employees, then its total expected operational risk losses would be reduced considerably.

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