When Does Linking Pay to Default Reduce Bank Risk?

To contain bankers' risk-shifting behavior, policymakers use a variety of tools. Among them, mandating the use of default-linked (i.e., debt-like) pay features prominently, typically in the form of bonus deferrals. In our model, a risk-neutral manager is in charge of choosing bank-level asset risk, receiving in exchange a compensation package consisting of a bonus and a default-linked component. In the spirit of existing regulation and widespread industry practices, we give the manager discretion over the allocation of the personal default-linked account between own bank's shares and an alternative asset. The possibility for the manager to tie the value of default-linked pay to equity weakens its debt-like feature and, in the same way, its ability to rein in excessive risk-taking. Bank leverage and bailout expectations appear to exacerbate these effects, which may be further aggravated by the endogenous shareholders' choice to design a more convex bonus as a response to mandatory default-linked pay. Our analysis raises concerns on the robustness of the theoretical foundations of some recent regulatory efforts.