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When Does Linking Pay to Default Reduce Bank Risk?

Author

Listed:
  • Stefano Colonnello

    (Department of Economics, Ca’ Foscari University of Venice)

  • Giuliano Curatola

    (University of Siena; Leibniz Institute for Financial Research SAFE)

  • Shuo Xia

    (Leipzig University; Halle Institute for Economic Research (IWH))

Abstract
To contain bankers' risk-shifting behavior, policymakers use a variety of tools. Among them, mandating the use of default-linked (i.e., debt-like) pay features prominently, typically in the form of bonus deferrals. In our model, a risk-neutral manager is in charge of choosing bank-level asset risk, receiving in exchange a compensation package consisting of a bonus and a default-linked component. In the spirit of existing regulation and widespread industry practices, we give the manager discretion over the allocation of the personal default-linked account between own bank's shares and an alternative asset. The possibility for the manager to tie the value of default-linked pay to equity weakens its debt-like feature and, in the same way, its ability to rein in excessive risk-taking. Bank leverage and bailout expectations appear to exacerbate these effects, which may be further aggravated by the endogenous shareholders' choice to design a more convex bonus as a response to mandatory default-linked pay. Our analysis raises concerns on the robustness of the theoretical foundations of some recent regulatory efforts.

Suggested Citation

  • Stefano Colonnello & Giuliano Curatola & Shuo Xia, 2024. "When Does Linking Pay to Default Reduce Bank Risk?," Working Papers 2024: 07, Department of Economics, University of Venice "Ca' Foscari".
    • Handle: RePEc:ven:wpaper:2024:07
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    References listed on IDEAS

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    More about this item

    Keywords

    Bank Risk-Taking; Banking Regulation; Default-Linked Compensation;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance
    • M12 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Administration - - - Personnel Management; Executives; Executive Compensation

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