A Game Theoretic Approach for Analyzing the System of Incentives and Restraints Present in Chinese Financial Systems

Abstract

Currently, the most important issue with respect to financial institutions is how to motivate staff without providing perverse incentives. For instance, with the implementation of a proper incentive system, staff will be motivated via their self-interest to create financial innovations to better price and hedge risk. However, this system must also be designed with checks and balances in mind because it is also very easy to institute a system in which perverse incentives drive individual behavior. In an effort to modernize the Chinese financial system, it is important to understand both the underlying mechanism by which people respond to incentives to better design compensation schemes that maximize innovation. Utilizing game theory, it is possible to analyze the interplay between these two drivers of human action. From this analysis it becomes possible to design better ways of compensating staff to curb undesirable behavior by those in the financial industry while still promoting innovation within the field.