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

28 Pages Posted: 11 Oct 2014

See all articles by Michael Hilmer

Michael Hilmer

Max Planck Institute for Tax Law and Public Finance; Ludwig Maximilian University of Munich (LMU) - Munich Graduate School of Economics (MGSE)

Date Written: October 7, 2014

Abstract

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.

Keywords: Bonus Tax, Executive Compensation, Bailout, Systemic Risk, Too Many To Fail, Collective

JEL Classification: H24, J30, M52, G38, D62

Suggested Citation

Hilmer, Michael, Too Many to Fail -- How Bonus Taxation Prevents Gambling for Bailouts (October 7, 2014). Working Paper of the Max Planck Institute for Tax Law and Public Finance No. 2014-18, Available at SSRN: https://ssrn.com/abstract=2506526 or http://dx.doi.org/10.2139/ssrn.2506526

Michael Hilmer (Contact Author)

Max Planck Institute for Tax Law and Public Finance ( email )

Marstallplatz 1
Munich, 80539
Germany

Ludwig Maximilian University of Munich (LMU) - Munich Graduate School of Economics (MGSE)

Kaulbachstrasse 45
München, 80539
Germany

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