Mandatory Deferral of Banker Compensation and Misallocation of Risky Projects

Abstract

We analyze the impact of mandatory deferral of bankers' compensation in a dynamic model with heterogenous banks. Shareholders are protected by limited liability, and hence implement excessive risk-taking of bank mangers by offering high powered incentive schemes. Deferral of payments reduces risk-shifting. However, deferred bonuses may backfire by distorting the allocation of risky projects within the banking sector. Moreover, we show that mandatory deferral of compensation is weakly welfare dominated by tighter capital requirements. For these two reasons, our model suggests that regulations on bankers' pay should only be considered if sufficiently tight capital requirements are infeasible.

Keywords: Deferred Bonuses, risk-shifting, financial crisis, Executive compensation

JEL Classification: G21, G28, J33, D62