Too Many to Fail - How Bonus Taxation Prevents Gambling for Bailouts

Michael Hilmer

Working Papers from Max Planck Institute for Tax Law and Public Finance

Abstract: Using a simple symmetric principal-agent model with two banks, we study the effects of both bailouts and bonus taxes on risk taking and managerial compensation. We assume financial institutions to be systemic only on a collective basis, implying support with bailouts only if they both fail collectively. This too-many-to-fail assumption generates incentives for herding and collective moral hazard. If banks can anticipate bailouts, they can coordinate on an equilibrium in which they collectively incentivize higher risk-taking. A bonus tax can prevent this excessive risk-taking, even if it is implemented unilaterally: proper bonus taxation reduces risk-taking of the taxed bank(s) and, consequentially, rules out the equilibrium with excessive risk-taking of both banks and reestablishes market discipline.

Keywords: Bonus Tax; Executive Compensation; Bailout; Systemic Risk; Too Many To Fail; Collective Moral Hazard (search for similar items in EconPapers)
JEL-codes: D62 G38 H24 J3 M52 (search for similar items in EconPapers)
Pages: 28 pages
Date: 2014-10
New Economics Papers: this item is included in nep-cta
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:mpi:wpaper:tax-mpg-rps-2014-18

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