Bankers’ Bonuses and Speculative Bubbles

MPI Collective Goods Preprint, No. 2010/44

University of Heidelberg, Department of Economics Discussion Paper No. 567

45 Pages Posted: 10 Nov 2010 Last revised: 17 Feb 2015

See all articles by Zeno Enders

Zeno Enders

University of Heidelberg

Hendrik Hakenes

Finance Group; Centre for Economic Policy Research (CEPR)

Date Written: February 2015

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

Suggested Citation

Enders, Zeno and Hakenes, Hendrik, Bankers’ Bonuses and Speculative Bubbles (February 2015). MPI Collective Goods Preprint, No. 2010/44; University of Heidelberg, Department of Economics Discussion Paper No. 567 . Available at SSRN: https://ssrn.com/abstract=1705943 or http://dx.doi.org/10.2139/ssrn.1705943

Zeno Enders

University of Heidelberg ( email )

Hendrik Hakenes (Contact Author)

Finance Group ( email )

Adenauerallee 24-42
D-53113 Bonn
Germany
+49-228-73-9225 (Phone)

HOME PAGE: http://www.finance.uni-bonn.de/hakenes

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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