Designing Bankers' Pay: Using Contingent Capital to Reduce Risk-shifting Incentives

Abstract

Including contingent convertible bonds (coco) in the capital structure of a bank affects the sensitivity to risk of its equity-based compensation. Such risk-shifting incentives can be reduced if the coco bonds are well-designed. Similarly, we show that compensating executives instead with well-designed coco bonds can also reduce risk-shifting incentives. In practice, however, most coco bonds have characteristics that result in both stock and coco compensation having large sensitivities to changes in asset risk -- equity-based compensation encourages executives to increase risk, coco compensation to reduce risk. We show that a pay package combining both stock and coco can practically eliminate risk-shifting incentives and that it can be implemented with a bank's preexisting coco bonds.

Keywords: contingent capital, executive compensation, risk-shifting, banking regulation, coco compensation

JEL Classification: G13, G21, G28, E58