IDEAS home Printed from https://ideas.repec.org/a/eee/corfin/v71y2021ics0929119921002261.html
   My bibliography  Save this article

Optimal regulation, executive compensation and risk taking by financial institutions

Author

Listed:
  • Hilscher, Jens
  • Landskroner, Yoram
  • Raviv, Alon

Abstract

We present an equilibrium model of financial institutions to examine the optimal regulation of risk taking. Shareholders provide incentives for management to increase risk to excessive levels. Regulators use caps on asset risk and compensation to achieve the socially optimal risk level. This level trades off costs of risk shifting and costs of bank default. Without regulation, equilibrium risk lies above the optimal level. If information and enforcement are perfect, either policy tool (caps on asset risk or compensation) achieves the optimal risk level. If there are frictions – if enforcement is limited, if there is uncertainty about the incentives facing management and costs of risk shifting, or if regulation cannot be bank specific – welfare can be improved by employing both policy tools.

Suggested Citation

  • Hilscher, Jens & Landskroner, Yoram & Raviv, Alon, 2021. "Optimal regulation, executive compensation and risk taking by financial institutions," Journal of Corporate Finance, Elsevier, vol. 71(C).
    • Handle: RePEc:eee:corfin:v:71:y:2021:i:c:s0929119921002261
    DOI: 10.1016/j.jcorpfin.2021.102104
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0929119921002261
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.jcorpfin.2021.102104?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Galai, Dan & Masulis, Ronald W., 1976. "The option pricing model and the risk factor of stock," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 53-81.
    2. Hugonnier, Julien & Morellec, Erwan, 2017. "Bank capital, liquid reserves, and insolvency risk," Journal of Financial Economics, Elsevier, vol. 125(2), pages 266-285.
    3. Jeremy C. Stein, 2012. "Monetary Policy as Financial Stability Regulation," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 127(1), pages 57-95.
    4. Fahlenbrach, Rüdiger & Stulz, René M., 2011. "Bank CEO incentives and the credit crisis," Journal of Financial Economics, Elsevier, vol. 99(1), pages 11-26, January.
    5. Rui Albuquerque & Luís Cabral & José Guedes, 2019. "Incentive Pay and Systemic Risk," Review of Financial Studies, Society for Financial Studies, vol. 32(11), pages 4304-4342.
    6. Miss Rita Babihuga & Marco Spaltro, 2014. "Bank Funding Costs for International Banks," IMF Working Papers 2014/071, International Monetary Fund.
    7. Patrick Bolton & Hamid Mehran & Joel Shapiro, 2015. "Executive Compensation and Risk Taking," Review of Finance, European Finance Association, vol. 19(6), pages 2139-2181.
    8. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, vol. 24(Win), pages 14-23.
    9. Gerard Caprio & Asli Demirgüç-Kunt & Edward J. Kane, 2010. "The 2007 Meltdown in Structured Securitization: Searching for Lessons, not Scapegoats," The World Bank Research Observer, World Bank, vol. 25(1), pages 125-155, February.
    10. Low, Angie, 2009. "Managerial risk-taking behavior and equity-based compensation," Journal of Financial Economics, Elsevier, vol. 92(3), pages 470-490, June.
    11. Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 77-100, Winter.
    12. Gilson, Stuart C., 1989. "Management turnover and financial distress," Journal of Financial Economics, Elsevier, vol. 25(2), pages 241-262, December.
    13. Viral Acharya & Marco Pagano & Paolo Volpin, 2016. "Seeking Alpha: Excess Risk Taking and Competition for Managerial Talent," The Review of Financial Studies, Society for Financial Studies, vol. 29(10), pages 2565-2599.
    14. Anginer, Deniz & Demirguc-Kunt, Asli & Zhu, Min, 2014. "How does deposit insurance affect bank risk? Evidence from the recent crisis," Journal of Banking & Finance, Elsevier, vol. 48(C), pages 312-321.
    15. repec:oup:rfinst:v:21:y:2017:i:5:p:1901-1932. is not listed on IDEAS
    16. Hoggarth, Glenn & Reis, Ricardo & Saporta, Victoria, 2002. "Costs of banking system instability: Some empirical evidence," Journal of Banking & Finance, Elsevier, vol. 26(5), pages 825-855, May.
    17. DeYoung, Robert, et al, 2001. "The Information Content of Bank Exam Ratings and Subordinated Debt Prices," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(4), pages 900-925, November.
    18. Allen, Franklin & Carletti, Elena & Goldstein, Itay & Leonello, Agnese, 2018. "Government guarantees and financial stability," Journal of Economic Theory, Elsevier, vol. 177(C), pages 518-557.
    19. Larry D. Wall, 2020. "Is stricter regulation of incentive compensation the missing piece?," Journal of Banking Regulation, Palgrave Macmillan, vol. 21(1), pages 82-94, March.
    20. Cerasi, Vittoria & Deininger, Sebastian M. & Gambacorta, Leonardo & Oliviero, Tommaso, 2020. "How post-crisis regulation has affected bank CEO compensation," Journal of International Money and Finance, Elsevier, vol. 104(C).
    21. Armen Hovakimian & Edward J. Kane & Luc Laeven, 2012. "Tracking Variation in Systemic Risk at US Banks During 1974-2013," NBER Working Papers 18043, National Bureau of Economic Research, Inc.
    22. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    23. Benjamin Bennett & Radhakrishnan Gopalan & Anjan Thakor, 2021. "How Are Bankers Paid? [The dark side of liquidity creation: Leverage and systemic risk]," The Review of Corporate Finance Studies, Society for Financial Studies, vol. 10(4), pages 788-812.
    24. Alex Edmans & Xavier Gabaix & Dirk Jenter, 2017. "Executive Compensation: A Survey of Theory and Evidence," NBER Working Papers 23596, National Bureau of Economic Research, Inc.
    25. Kim, Daesik & Santomero, Anthony M, 1988. " Risk in Banking and Capital Regulation," Journal of Finance, American Finance Association, vol. 43(5), pages 1219-1233, December.
    26. Thanassoulis, John & Tanaka, Misa, 2018. "Optimal pay regulation for too-big-to-fail banks," Journal of Financial Intermediation, Elsevier, vol. 33(C), pages 83-97.
    27. Douglas Gale & Andrea Gamba & Marcella Lucchetta, 2018. "Dynamic Bank Capital Regulation in Equilibrium," 2018 Meeting Papers 680, Society for Economic Dynamics.
    28. Andrei Shleifer & Robert W. Vishny, 2010. "Asset Fire Sales and Credit Easing," American Economic Review, American Economic Association, vol. 100(2), pages 46-50, May.
    29. John, Kose & Mehran, Hamid & Qian, Yiming, 2010. "Outside monitoring and CEO compensation in the banking industry," Journal of Corporate Finance, Elsevier, vol. 16(4), pages 383-399, September.
    30. Suarez, Javier & Mendicino, Caterina & Nikolov, Kalin, 2017. "Equity versus Bail-in Debt in Banking: An Agency Perspective," CEPR Discussion Papers 12104, C.E.P.R. Discussion Papers.
    31. Fama, Eugene F, 1980. "Agency Problems and the Theory of the Firm," Journal of Political Economy, University of Chicago Press, vol. 88(2), pages 288-307, April.
    32. John, Kose & Saunders, Anthony & Senbet, Lemma W, 2000. "A Theory of Bank Regulation and Management Compensation," Review of Financial Studies, Society for Financial Studies, vol. 13(1), pages 95-125.
    33. Hilscher, Jens & Raviv, Alon, 2014. "Bank stability and market discipline: The effect of contingent capital on risk taking and default probability," Journal of Corporate Finance, Elsevier, vol. 29(C), pages 542-560.
    34. Julian Kolm & Christian Laux & Gyöngyi Lóránth, 2017. "Bank Regulation, CEO Compensation, and Boards," Review of Finance, European Finance Association, vol. 21(5), pages 1901-1932.
    35. Ronn, Ehud I & Verma, Avinash K, 1986. "Pricing Risk-Adjusted Deposit Insurance: An Option-Based Model," Journal of Finance, American Finance Association, vol. 41(4), pages 871-895, September.
    36. Christian Eufinger & Andrej Gill, 2017. "Incentive-Based Capital Requirements," Management Science, INFORMS, vol. 63(12), pages 4101-4113, December.
    37. Berger, Allen N & Davies, Sally M & Flannery, Mark J, 2000. "Comparing Market and Supervisory Assessments of Bank Performance: Who Knows What When?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 641-667, August.
    38. John R. Graham & Hyunseob Kim & Si Li & Jiaping Qiu, 2019. "Employee Costs of Corporate Bankruptcy," NBER Working Papers 25922, National Bureau of Economic Research, Inc.
    39. Raviv, Alon & Sisli-Ciamarra, Elif, 2013. "Executive compensation, risk taking and the state of the economy," Journal of Financial Stability, Elsevier, vol. 9(1), pages 55-68.
    40. John Thanassoulis, 2012. "The Case for Intervening in Bankers’ Pay," Journal of Finance, American Finance Association, vol. 67(3), pages 849-895, June.
    41. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
    42. Purnanandam, Amiyatosh, 2008. "Financial distress and corporate risk management: Theory and evidence," Journal of Financial Economics, Elsevier, vol. 87(3), pages 706-739, March.
    43. Christopher Martin & Manju Puri & Alexander Ufier, 2018. "Deposit Inflows and Outflows in Failing Banks: The Role of Deposit Insurance," NBER Working Papers 24589, National Bureau of Economic Research, Inc.
    44. Rene M. Stulz, 2016. "Risk management, governance, culture, and risk taking in banks," Economic Policy Review, Federal Reserve Bank of New York, issue Aug, pages 43-60.
    45. Gornall, Will & Strebulaev, Ilya A., 2018. "Financing as a supply chain: The capital structure of banks and borrowers," Journal of Financial Economics, Elsevier, vol. 129(3), pages 510-530.
    46. Manthos D. Delis & Panagiotis K. Staikouras, 2011. "Supervisory Effectiveness and Bank Risk," Review of Finance, European Finance Association, vol. 15(3), pages 511-543.
    47. Coles, Jeffrey L. & Daniel, Naveen D. & Naveen, Lalitha, 2006. "Managerial incentives and risk-taking," Journal of Financial Economics, Elsevier, vol. 79(2), pages 431-468, February.
    48. Rangarajan K. Sundaram & David L. Yermack, 2007. "Pay Me Later: Inside Debt and Its Role in Managerial Compensation," Journal of Finance, American Finance Association, vol. 62(4), pages 1551-1588, August.
    49. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    50. Hayne E. Leland., 1998. "Agency Costs, Risk Management, and Capital Structure," Research Program in Finance Working Papers RPF-278, University of California at Berkeley.
    51. Lucian A. Bebchuk & Yaniv Grinstein & Urs Peyer, 2010. "Lucky CEOs and Lucky Directors," Journal of Finance, American Finance Association, vol. 65(6), pages 2363-2401, December.
    52. Mendicino, Caterina & Nikolov, Kalin & Suarez, Javier, 2017. "Equity versus Bail-in Debt in Banking: An Agency Perspective," CEPR Discussion Papers 12104, C.E.P.R. Discussion Papers.
    53. Viral V. Acharya & Paolo F. Volpin, 2010. "Corporate Governance Externalities," Review of Finance, European Finance Association, vol. 14(1), pages 1-33.
    54. Marcus, Alan J & Shaked, Israel, 1984. "The Valuation of FDIC Deposit Insurance Using Option-pricing Estimates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 16(4), pages 446-460, November.
    55. Palmon, Oded & Bar-Yosef, Sasson & Chen, Ren-Raw & Venezia, Itzhak, 2008. "Optimal strike prices of stock options for effort-averse executives," Journal of Banking & Finance, Elsevier, vol. 32(2), pages 229-239, February.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Abudy, Menachem Meni & Gavious, Ilanit & Shust, Efrat, 2023. "Does adopting voluntary ESG practices affect executive compensation?," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 83(C).

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Raviv, Alon & Sisli-Ciamarra, Elif, 2013. "Executive compensation, risk taking and the state of the economy," Journal of Financial Stability, Elsevier, vol. 9(1), pages 55-68.
    2. Heller, Yuval & Peleg Lazar, Sharon & Raviv, Alon, 2022. "Banks’ risk taking and creditors’ bargaining power," Journal of Corporate Finance, Elsevier, vol. 74(C).
    3. Colonnello, Stefano & Koetter, Michael & Wagner, Konstantin, 2023. "Compensation regulation in banking: Executive director behavior and bank performance after the EU bonus cap," Journal of Accounting and Economics, Elsevier, vol. 76(1).
    4. Sharon Peleg†Lazar & Alon Raviv, 2017. "Bank Risk Dynamics Where Assets are Risky Debt Claims," European Financial Management, European Financial Management Association, vol. 23(1), pages 3-31, January.
    5. Chesney, Marc & Stromberg, Jacob & Wagner, Alexander F. & Wolff, Vincent, 2020. "Managerial incentives to take asset risk," Journal of Corporate Finance, Elsevier, vol. 65(C).
    6. Belkhir, Mohamed & Boubaker, Sabri, 2013. "CEO inside debt and hedging decisions: Lessons from the U.S. banking industry," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 24(C), pages 223-246.
    7. Srivastav, Abhishek & Armitage, Seth & Hagendorff, Jens & King, Tim, 2018. "Better safe than sorry? CEO inside debt and risk-taking in bank acquisitions," Journal of Financial Stability, Elsevier, vol. 36(C), pages 208-224.
    8. Patricia Boyallian & Pablo Ruiz-Verdú, 2018. "Leverage, CEO Risk-Taking Incentives, and Bank Failure during the 2007–10 Financial Crisis [Endogenous matching and the empirical determinants of contract form]," Review of Finance, European Finance Association, vol. 22(5), pages 1763-1805.
    9. repec:cte:wbrepe:wb1501 is not listed on IDEAS
    10. Koch, Christoffer & Okamura, Ken, 2019. "Why does the FDIC sue?," Journal of Corporate Finance, Elsevier, vol. 59(C), pages 255-275.
    11. Jeong-Bon Kim & Li Li & Mary L. Z. Ma & Frank M. Song, 2013. "CEO Option Compensation, Risk-Taking Incentives, and Systemic Risk in the Banking Industry," Working Papers 182013, Hong Kong Institute for Monetary Research.
    12. Peleg Lazar, Sharon & Raviv, Alon, 2019. "The risk spiral: The effects of bank capital and diversification on risk taking," International Review of Financial Analysis, Elsevier, vol. 65(C).
    13. Rose Neng Lai & Robert Order, 2014. "Securitization, Risk-Taking and the Option to Change Strategy," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 42(2), pages 343-362, June.
    14. Bennett, Rosalind L. & Güntay, Levent & Unal, Haluk, 2015. "Inside debt, bank default risk, and performance during the crisis," Journal of Financial Intermediation, Elsevier, vol. 24(4), pages 487-513.
    15. Raviv, Alon & Hilscher, Jens & Peleg Lazar, Sharon, 2021. "Designing bankers' pay: Using contingent capital to reduce risk-shifting," MPRA Paper 106596, University Library of Munich, Germany.
    16. Ernest Dautovic, 2019. "Has Regulatory Capital Made Banks Safer? Skin in the Game vs Moral Hazard," Cahiers de Recherches Economiques du Département d'économie 19.03, Université de Lausanne, Faculté des HEC, Département d’économie.
    17. Ongena, Steven & Savaşer, Tanseli & Şişli Ciamarra, Elif, 2022. "CEO incentives and bank risk over the business cycle," Journal of Banking & Finance, Elsevier, vol. 138(C).
    18. Hilscher, Jens & Raviv, Alon, 2014. "Bank stability and market discipline: The effect of contingent capital on risk taking and default probability," Journal of Corporate Finance, Elsevier, vol. 29(C), pages 542-560.
    19. King, Timothy & Srivastav, Abhishek & Williams, Jonathan, 2016. "What's in an education? Implications of CEO education for bank performance," Journal of Corporate Finance, Elsevier, vol. 37(C), pages 287-308.
    20. Jobst, Andreas A., 2014. "Measuring systemic risk-adjusted liquidity (SRL)—A model approach," Journal of Banking & Finance, Elsevier, vol. 45(C), pages 270-287.
    21. Monda, Barbara & Giorgino, Marco & Modolin, Ileana, 2013. "Rationales for Corporate Risk Management - A Critical Literature Review," MPRA Paper 45420, University Library of Munich, Germany.

    More about this item

    Keywords

    Bank regulation; Financial institutions; Executive compensation; Risk taking; Financial crises;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:corfin:v:71:y:2021:i:c:s0929119921002261. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/jcorpfin .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.