Bankers’ Bonuses and Speculative Bubbles

Abstract

We develop a parsimonious model of bubbles based on the assumption of imprecisely known market depth. In a speculative bubble, bankers (traders) drive the price above its fundamental value in a dynamic way, driven by rational expectations about future price developments. At a previously unknown date, the bubble will endogenously burst. We provide a general condition for the possibility of bubbles depending on the risk-free rate, uncertainty about market depth, banks’ degree of leverage, and bankers’ bonus structure. This allows us to discuss several policy measures. Bubbles always reduce aggregate welfare. Households are nevertheless willing to lend to bankers when bubbles are likely. Among others, capping bonuses, minimum leverage ratios, certain monetary policy rules, and a correctly implemented Tobin tax can prevent their occurrence. Implemented incorrectly, however, some of these measures—bonus regulations in particular—backfire and facilitate bubbles.

Keywords: Bubbles, Rational Expectations, Market Depth, Liquidity, Financial Crises, Leveraged Investment, Bonuses, Capital Structure

JEL Classification: E44, G01, G12