We provide the first evidence that prudential principles shape bankers' executive compensation, a phenomenon we call “pay for prudence” (PfP). We conjecture that PfP incentivizes bankers to balance shareholders' preference for risk with regulators' preference for prudence. Although PfP terms are often used in bank compensation contracts, we find that the use of detailed and concrete PfP terms are positively associated with equity incentives for risk-taking. Furthermore, detailed and concrete PfP terms are associated with lower tail risk, fewer bad loans, and lower likelihood of regulatory downgrades. While we do not find evidence that PfP is associated with lower profitability, PfP is associated with more diversified loan portfolios and reduced exposure to real estate. Our results shed light on a new dimension of bankers' pay and suggest that PfP-based incentives complement widely studied equity-based incentives for risk-taking by acting as guard rails that guide managers’ pursuit of investment opportunities.

We provide evidence that financial shocks to lenders influence the composition of financial covenants in debt contracts. Using two distinct measures of lender-specific shocks—defaults in a lender's corporate loan portfolio that occur outside the borrower's region and industry, and non-corporate loan delinquencies—we show that lenders respond to financial shocks by increasing the number and strictness of performance-based but not of capital-based covenants in debt contracts. We examine two possible channels for this result. We find evidence consistent with lenders using stricter control rights because of concerns about capital depletion (a capital channel) and because of new information about lenders' own screening ability (a learning channel). Our results indicate that lender preferences influence how accounting information is used in debt contracts.

ABSTRACT We examine the relation between debt contract renegotiation costs and contract design. We use a plausibly exogenous shock to expected renegotiation costs arising from a change in the taxation of debt renegotiations to show that, as renegotiation costs decline, the maturity of debt contracts lengthens, the initial likelihood of covenant violation increases, and the use of performance pricing provisions becomes less frequent. The evidence indicates that ex ante allocation of cash flow rights and ex post reallocation of decision rights through renegotiation are local substitutes, where the preference for one mechanism versus the other depends, at least in part, on renegotiation costs. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: G32; G33; G38.