Working Paper: CEPR ID: DP8852
Authors: Hendrik Hakenes; Isabel Schnabel
Abstract: This paper shows that bonus contracts may arise endogenously as a response to agency problems within banks, and analyzes how compensation schemes change in reaction to anticipated bail-outs. If there is a risk-shifting problem, bail-out expectations lead to steeper bonus schemes and even more risk-taking. If there is an effort problem, the compensation scheme becomes flatter and effort decreases. If both types of agency problems are present, a sufficiently large increase in bail-out perceptions makes it optimal for a welfare-maximizing regulator to impose caps on bank bonuses. In contrast, raising managers? liability is counterproductive.
Keywords: Bank bailouts; Bank management compensation; Bonus payments; Limited and unlimited liability; Risk-shifting; Underinvestment
JEL Codes: G21; G28; J33; M52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increase in bailout expectations (G28) | Steeper bonus schemes (J33) |
| Steeper bonus schemes (J33) | Increased risk-taking (G41) |
| Increased risk-taking (G41) | Increased probability of bank defaults (F65) |
| Increase in bailout expectations (G28) | Increased probability of bank defaults (F65) |
| Increase in bailout expectations (G28) | Flatter compensation schemes (J33) |
| Flatter compensation schemes (J33) | Decreased managerial effort (D29) |
| Decreased managerial effort (D29) | Increased probability of bank defaults (F65) |