Cash holdings and bank compensation

The experience of the 2007-09 financial crisis has prompted much consideration of the link between the structure of compensation in financial firms and excessive risk taking by their employees. A key concern has been that compensation design rewards managers for pursuing risky strategies but fails to exact penalties for decision making that leads to bank failures, financial system disruption, government bailouts, and taxpayer losses. As a way to better align management's interests with those of other stakeholders such as creditors and taxpayers, the authors propose a cash holding requirement designed to induce financial firms to adopt a conservative approach to risk taking. Firms meet the requirement by deferring employee compensation in an escrowed cash reserve account. The cash accrues to the earners on a vesting schedule, but is transferred to the firm in times of stress so that it can pay down its debt or otherwise bolster its assets. The cash requirement increases with the leverage of the firm and with the firm's vulnerability to aggregate stress; the authors provide illustrative calculations sizing the proposed cash requirement for many U.S. financial firms over the 2000-13 period. The analysis also compares the role of deferred cash compensation in promoting financial stability with that of other instruments, such as inside debt, deferred equity, and contingent capital.