Authors: Patrick Bolton, Hamid Mehran, and Joel Shapiro

This paper studies the connection between risk taking and executive compensation in financial institutions. A theoretical model of shareholders, debtholders, depositors, and an executive demonstrates that 1) excessive risk taking (in the form of risk shifting) can be addressed by basing compensation on both stock price and the price of debt (proxied by the credit default swap spread), 2) shareholders may not be able to commit to designing compensation contracts in this way, and 3) they may not want to because of distortions introduced by either deposit insurance or trusting debtholders. The paper also provides an empirical analysis that suggests that debt-like compensation for executives is believed by the market to reduce risk for financial institutions.