Escrow and Clawback

Since the financial crisis in 2008, clawback provisions have been implemented by several high profile banks and are also required by some regulators to mitigate the cost in case of a catastrophic shift in business, and also to deter excessive risk taking. In this thesis, we construct a model to investigate the long term effect on the bank's revenue of a trader's bonus payment scheme with escrow. We formulate the problem as an infinite-horizon discrete dynamic programming problem. With the proposed model, the trader's optimal investment and consumption strategy can be expressed by explicit analytic formulas, both with and without escrowing the bonus, which enables the calculation and comparison of the bank's total expected revenue under these two bonus payment schemes. The final conclusion of this comparison depends on the parameters describing the trader's risk appetite, the discount factor and the bank's level of patience, in addition to the market parameters. In particular, when the model parameters are such that the bank's total expected discounted revenue is finite under both types of bonus payment schemes, and the bank is sufficiently patient, it is better o when escrowing the trader's bonus, although not escrowing the trader's bonus brings better short term revenue.