Compensation contracts and fire sales

•This paper analyzes the impact of remuneration practices on banks’ risk-taking in a model with fire sales externalities.•Plain-vanilla equity fails to internalize fire sales externalities. Deferred equity and long-term bonuses unrelated to short-term profits can restore social efficiency.•Bail-in bonds can achieve efficiency at a smaller cost since they allow for state-contingent payments.•It is not the level but the composition of variable compensation that determines the inefficiency. Excessive regulation may lead to suboptimal levels of risk-taking.•Government guarantees reinforce the fire sales externalities and the need for regulation.

This paper analyzes the impact of remuneration practices on banks’ risk-taking in a model with fire sales externalities. When these externalities are not internalized by a bank's shareholders and executives, borrowing and fire sales are higher than the socially optimal level. Our analysis shows that plain-vanilla equity fails to internalize fire sales externalities. Deferred equity and long-term bonuses unrelated to short-term profits can restore social efficiency. Bail-in bonds can achieve efficiency at a smaller cost since they allow for state-contingent payments. It is not the level but the composition of variable compensation that determines the inefficiency. Excessive regulation may lead to suboptimal levels of risk-taking. Government guarantees reinforce the fire sales externalities and the need for regulation.