Financial Sector Incentives, Bailouts, Moral Hazard, Systemic Risk, and Reforms

This article proposes a mechanism for injecting government funds as needed to restore financial stability during a crisis while ensuring that any taxpayer rescue funds that a firm is unable to repay serve to trigger individual financial losses for the financial industry professionals who were responsible for the lost taxpayer funds. This mechanism involves bonds that convert to equity after five years, in combination with regulations requiring that a significant portion of compensation must be deferred and paid in the form of stock options whose value would depend on the safety of decisions made in prior years. This mechanism is analyzed using a model of systemic risk and calculations of the magnitude of incentives to reduce risk.