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 study whether recognition versus disclosure affects debt contracting using SFAS 158 as a setting. Upon recognition of previously disclosed pension liabilities, we find that debt contracts of firms that have high pension underfunding contain relatively more covenants based on the balance sheet and a lower cost of debt. Additional analysis suggests that improved reliability of recognized information is a likely mechanism for these findings. We also document that recognition did not affect the credit risk of the borrower or the use of income statement–based covenants that were unaffected by the accounting standard change. Collectively, our evidence suggests that recognition of previously disclosed accounting information can facilitate the incorporation of that information into lenders’ screening and monitoring. Data Availability: Data used in this study are available from public sources identified in the study.