Bank Capital Requirements and Mandatory Deferral of Compensation

Tighter capital requirements and mandatory deferral of compensation are among the most prominently advocated regulatory measures to reduce excessive risk-taking in the banking industry. We analyze the interplay of the two instruments in an economy with two heterogenous banks that can fund uncorrelated projects with fully diversifiable risk or correlated projects with systemic risk. If both project types are in abundant supply, we find that full mandatory deferral of compensation is beneficial as it allows for weaker capital requirements, and hence for a larger banking sector, without increasing the incentives for risk-shifting. With competition for uncorrelated projects, however, deferred compensation may misallocate correlated projects to the bank which is inferior in managing risks. Our findings challenge the current tendency to impose stricter regulations on more sophisticated institutes.