Working Paper No. 558
By John Thanassoulis and Misa Tanaka
This paper studies the agency problem between bank management, shareholders, and the taxpayer. Executive bonuses increase in the probability the bank is too big to fail. Bank management recognise it is very likely optimal to select risky projects which exploit the taxpayer, implying project selection effort (eg due diligence) is more expensive to incentivise. This agency problem leads to too much risk for society, not for shareholders. Compensation rules aimed at solving management-shareholder agency problems — equity pay, deferred, including debt — do not correct the excessive risk taking. By contrast, malus and clawbacks can incentivise the bank management to make better risk choices.
This is an updated version of the Staff Working Paper originally published on 9 October 2015. The title of the paper has now been changed to 'Optimal pay regulations for too-big-to-fail banks'.