This paper argues that the presence of both profit-based and stock price-based components in compensation contracts provides senior managers the incentive to optimally allocate effort to both implementing previously devised strategies that provide current profits and to formulating new strategies that create shareholder value. If managers are concerned about their reputation and if outcomes of strategy implementation are more informative about their ability than outcomes of strategy formulation, compensation based only on profit will incent managers to boost their reputation by over-allocating effort to strategy implementation. To restore the balance the contract needs to contain some stock-based compensation.

This paper argues that banks must be sufficiently levered to have first-best incentives to make new risky loans. This result, which is at odds with the notion that leverage invariably leads to excessive risk taking, derives from two key premises that focus squarely on the role of banks as informed lenders. First, banks finance projects that they do not own, which implies that they cannot extract all the profits. Second, banks conduct a credit risk analysis before making new loans. Our model may help understand why banks take on additional unsecured debt, such as unsecured deposits and subordinated loans, over and above their existing deposit base. It may also help understand why banks and finance companies have similar leverage ratios, even though the latter are not deposit takers and hence not subject to the same regulatory capital requirements as banks.