FRM Part II · FRM Exam Part II · Governance

A bank's executives are comparing two bonus designs for a credit portfolio manager. Design X pays 100% of the bonus in cash immediately. Design Y pays 40% immediately and defers 60% over three years, with the deferred part forfeited if realized portfolio losses exceed expected losses. The manager can choose between a low-risk strategy and a high-risk strategy with higher short-term spread income but a small chance of large later losses. Which statement best describes the likely effect?

Design Y reduces the incentive for the high-risk strategy because 60% of the bonus is deferred and forfeited if losses exceed expectations, so the manager bears part of the later tail risk. Design X pays everything immediately and ignores later losses, leaving them with the bank.

1. ADesign X better discourages the high-risk strategy because cash is received sooner and is therefore less uncertain
2. BBoth designs create identical incentives because the total bonus amount is the same
3. CDesign Y reduces the incentive to take the high-risk strategy because the deferred portion is exposed to later losses, while Design X ignores themCorrect
4. DDesign Y encourages the high-risk strategy because the manager receives less cash upfront and must make up the difference