Discussion Paper Details

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Title: On the Economics of Crisis Contracts

Author(s): Aptus Elias, Hans Gersbach and Britz Volker

Publication Date: May 2016

Keyword(s): Banker's Pay, banking crises, Capital requirements, Crisis Contracts, Excessive Risk Taking and Hedging

Programme Area(s): Financial Economics and Industrial Organization

Abstract: We examine the impact of so-called "Crisis Contracts" on bank managers' risk-taking incentives and on the probability of banking crises. Under a Crisis Contract, managers are required to contribute a pre-specified share of their past earnings to finance public rescue funds when a crisis occurs. This can be viewed as a retroactive tax that is levied only when a crisis occurs and that leads to a form of collective liability for bank managers. We develop a game-theoretic model of a banking sector whose shareholders have limited liability, so that society at large will suffer losses if a crisis occurs. Without Crisis Contracts, the managers' and shareholders' interests are aligned, and managers take more than the socially optimal level of risk. We investigate how the introduction of Crisis Contracts changes the equilibrium level of risk-taking and the remuneration of bank managers. We establish conditions under which the introduction of Crisis Contracts will reduce the probability of a banking crisis and improve social welfare. We explore how Crisis Contracts and capital requirements can supplement each other and we show that the efficacy of Crisis Contracts is not undermined by attempts to hedge.

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Bibliographic Reference

Elias, A, Gersbach, H and Volker, B. 2016. 'On the Economics of Crisis Contracts'. London, Centre for Economic Policy Research.