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Abstract

Using a principal-agent model with two-periods, we analyze the effects of both bailouts and bonus taxation on managerial compensation and short-termism. In our model, short-termism increases expected short-term profits at the expense of expected long-term profits and is harmful not only for society, but also for the bank itself. By neglecting the costs of failure, an anticipated bailout induces the bank to tolerate short-termist behavior more often. In addition, existing excessive short-termism increases further in the anticipated bailout payment, while compensation shifts from long-term towards short-term compensation. However, an appropriate tax on short-term bonuses can induce the bank to internalize the costs of a bailout. Consequently, our model offers a rationale for such a tax when banks anticipate bailouts and adjust their compensation payments accordingly.