Too Many to Fail -- How Bonus Taxation Prevents Gambling for Bailouts

Using a simple symmetric principal-agent model with two banks, we study the effects of both bailouts and bonus taxes on risk taking and managerial compensation. We assume financial institutions to be systemic only on a collective basis, implying support with bailouts only if they both fail collectively. This too-many-to-fail assumption generates incentives for herding and collective moral hazard. If banks can anticipate bailouts, they can coordinate on an equilibrium in which they collectively incentivize higher risk-taking. A bonus tax can prevent this excessive risk-taking, even if it is implemented unilaterally: proper bonus taxation reduces risk-taking of the taxed bank(s) and, consequentially, rules out the equilibrium with excessive risk-taking of both banks and reestablishes market discipline.