Abstract
Financial innovation may cause negative externalities and thus requires government interventions to correct incentives. However, with imperfect information, a simple Pigouvian tax cannot be implemented. We suggest to link the compensation of supervisors to the compensation of decision makers via a tax on the latter. Apart from inducing lower compensation in the financial sector, this mechanism provides an incentive for financial institutions to design contracts discouraging rent-seeking. As high compensation for rent-seeking would indirectly increase wages and thus talent of supervisors, it would also increase the expected punishment. Therefore, private rewards for rent-seeking will be reduced which improves economic efficiency.
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