Crisis Contracts

Abstract

We examine the impact of so-called Crisis Contracts. Under a Crisis Contract, bank managers are required to contribute a pre-specified share of their past earnings to finance public rescue funds when a crisis occurs. This leads to a form of collective responsibility for bank managers. We develop a game-theoretic model of a banking sector whose shareholders have limited liability. Without Crisis Contracts, the managers’ and shareholders’ interests are aligned, and managers take more than the socially optimal level of risk, so that a socially costly crisis may occur. Crisis Contracts change the equilibrium level of risk-taking and the remuneration of bank managers. We establish conditions under which the introduction of Crisis Contracts reduces the probability of a banking crisis and improves social welfare. We explore how Crisis Contracts and capital requirements can supplement each other and we show that the effectiveness of Crisis Contracts is not undermined by attempts to hedge.