DP8852 Bank Bonuses and Bail-outs

Author(s): Hendrik Hakenes, Isabel Schnabel
Publication Date: February 2012
Keyword(s): bank bail-outs, bank management compensation, bonus payments, limited and unlimited liability, risk-shifting, underinvestment
JEL(s): G21, G28, J33, M52
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8852

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.