Compensation contracts and fire sales

Pedro Gete and Juan-Pedro Gómez

Journal of Financial Stability, 2015, vol. 18, issue C, 154-171

Abstract: This paper analyzes the impact of remuneration practices on banks’ risk-taking in a model with fire sales externalities. When these externalities are not internalized by a bank's shareholders and executives, borrowing and fire sales are higher than the socially optimal level. Our analysis shows that plain-vanilla equity fails to internalize fire sales externalities. Deferred equity and long-term bonuses unrelated to short-term profits can restore social efficiency. Bail-in bonds can achieve efficiency at a smaller cost since they allow for state-contingent payments. It is not the level but the composition of variable compensation that determines the inefficiency. Excessive regulation may lead to suboptimal levels of risk-taking. Government guarantees reinforce the fire sales externalities and the need for regulation.

Keywords: Executive compensation; Bail-in bonds; Deferred equity; Fire sales (search for similar items in EconPapers)
JEL-codes: G20 G28 G30 (search for similar items in EconPapers)
Date: 2015
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:finsta:v:18:y:2015:i:c:p:154-171

DOI: 10.1016/j.jfs.2015.04.002

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