Abstract
We analyze the interplay of capital requirements and mandatory deferral of compensation in reducing banks’ risk taking incentives. Two heterogenous banks fund uncorrelated projects with fully diversifiable risk or correlated projects with systematic risk. One of both banks can identify project types and is superior at managing risks. If projects are in abundant supply, full mandatory deferral of compensation is optimal as it allows a larger banking sector without increasing the default risk. With limited supply of projects, deferred compensation may misallocate risky projects to the bank that is inferior at managing risks, so that early compensation may be optimal.
Highlights
1.1 Motivation and main resultsIn the aftermath of the financial crisis, tighter capital requirements (e.g. Admati and Hellwig 2014) and mandatory deferral of bankers’ compensation (e.g. Bebchuk and Fried 2010) are the two most prominent suggestions for mitigating the incentives for excessive risk-taking
We analyze the interplay of capital requirements and mandatory deferral of compensation in reducing banks’ risk taking incentives
If projects are in abundant supply, full mandatory deferral of compensation is optimal as it allows a larger banking sector without increasing the default risk
Summary
In the aftermath of the financial crisis, tighter capital requirements (e.g. Admati and Hellwig 2014) and mandatory deferral of bankers’ compensation (e.g. Bebchuk and Fried 2010) are the two most prominent suggestions for mitigating the incentives for excessive risk-taking. Feess holders can externalize part of the default risk to either depositors who do not fully react by demanding appropriately larger interest rates or, via bail-outs, to society That this agency cost of debt cannot be completely eliminated by relying exclusively on equity finance is a distinctive feature of banks, whose role as financial intermediaries requires them to raise a large amount of debt in the form of deposits. By contrast to early compensation, bank managers know that they are (fully) paid only in case of solvency, and demand a higher salary in the non-bankruptcy state This reduces the shareholders’ expected return on equity with risky projects. The potential downside of tight capital requirements that even projects with positive net present value will remain unfunded (credit crunch) can be mitigated by mandatory deferral of compensation In this sense, our basic model makes a point in favor of payment regulation. It is no exception that remuneration exceeds 30% of shareholder equity, and the ratio sometimes exceeds even 80% of shareholder equity; something rarely observed in non-financial firms (Thanassoulis 2014)
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