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Designing Bankers’ Pay: Using Contingent Capital to Reduce Risk-Shifting Incentives

Author

Listed:
  • Jens Hilscher

    (University of California, Davis, USA)

  • Sharon Peleg Lazar

    (Graduate School of Business Administration, Bar-Ilan University, Ramat Gan, Israel)

  • Alon Raviv

    (Graduate School of Business Administration, Bar-Ilan University, Ramat Gan, Israel)

Abstract

Including contingent convertible bonds (coco) in the capital structure of a bank affects the sensitivity to risk of its equity-based compensation. Such risk-shifting incentives can be reduced if the coco bonds are well-designed. Similarly, we show that compensating executives with well-designed coco bonds can also reduce risk-shifting incentives. In practice, however, most coco bonds have characteristics that result in both stock and coco compensation having large sensitivities to changes in asset risk — equity-based compensation encourages executives to increase risk, coco compensation to reduce risk. We show that a pay package combining both stock and coco can practically eliminate risk-shifting incentives and that it can be implemented with a bank’s preexisting coco bonds.

Suggested Citation

  • Jens Hilscher & Sharon Peleg Lazar & Alon Raviv, 2022. "Designing Bankers’ Pay: Using Contingent Capital to Reduce Risk-Shifting Incentives," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 12(01), pages 1-22, March.
    • Handle: RePEc:wsi:qjfxxx:v:12:y:2022:i:01:n:s2010139222400055
    DOI: 10.1142/S2010139222400055
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