Bank Bonuses and Bail-outs

Author(s): Hendrik Hakenes, Isabel Schnabel

CEPR Discussion Paper Number 8852
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Programme Area(s): Financial Economics (FE)

Date of Publication: 23/02/2012

Keyword(s): bank bail-outs, bank management compensation, bonus payments, limited and unlimited liability, risk-shifting, underinvestment

JEL(s): G21, G28, J33, M52

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.

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