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Compensation contracts and fire sales

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  • Gete, Pedro
  • Gómez, Juan-Pedro

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.

Suggested Citation

  • Gete, Pedro & Gómez, Juan-Pedro, 2015. "Compensation contracts and fire sales," Journal of Financial Stability, Elsevier, vol. 18(C), pages 154-171.
    • Handle: RePEc:eee:finsta:v:18:y:2015:i:c:p:154-171
    DOI: 10.1016/j.jfs.2015.04.002
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    Cited by:

    1. Pedro Gete & Juan-Pedro Gómez, 2018. "Dealing with Overleverage: Restricting Leverage vs. Restricting Variable Compensation," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 8(01), pages 1-29, March.

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    More about this item

    Keywords

    Executive compensation; Bail-in bonds; Deferred equity; Fire sales;
    All these keywords.

    JEL classification:

    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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