Designing Bankers' Pay: Using Contingent Capital to Reduce Risk-shifting Incentives
25 Pages Posted: 9 Mar 2021 Last revised: 28 May 2021
Date Written: April 13, 2021
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
Suggested Citation: Suggested Citation