This paper investigates the impact of changes in the intensity of moral hazard on the optimal provision of incentives during a contractual relationship. We develop a continuoustime principal-agent model in which the agent’s benefit from diverting cash flow is subject to a persistent and exogenous shock. We interpret this shock as a new regulation that decreases the fraction of diverted cash flows accessible to the manager. Our results show that managerial compensation becomes compressed following such regulation, as an high-performing manager receives lower compensation, while an underperforming manager receives higher compensation. Furthermore, we demonstrate that this type of regulation leads to the over-retention of underperforming managers. Although reduced agency friction results in increased profitability, the unintended consequences of the regulation include higher compensation for underperformers and their over-retention. Nonetheless, we also show that a competitive labor market can help mitigate these adverse effects arising from a decrease in the severity of agency friction.