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

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  • Michael Hilmer
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    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.

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    File URL: http://www.tax.mpg.de/RePEc/mpi/wpaper/TAX-MPG-RPS-2014-18.pdf
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    Paper provided by Max Planck Institute for Tax Law and Public Finance in its series Working Papers with number tax-mpg-rps-2014-18.

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    Length: 28 pages
    Date of creation: Oct 2014
    Handle: RePEc:mpi:wpaper:tax-mpg-rps-2014-18
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