Agency Incentives and Reputational Distortions: a Comparison of the Effectiveness of Value-at-Risk and Pre-commitment in Regulating Market Risk

In regulating the market risk exposure of banks, the approach taken to date is (in either the Standard or the Value-at-Risk methodology) to use a 'hard-link' regime that sets a fixed relation between exposure and capital requirement exogenously. A new 'Pre-commitment' approach (PCA) proposes the use of a 'soft-link'. Such a link is not externally imposed, but arises endogenously. In other words, it relies on the interaction between the bank owner and managers which is based on the preferences of both parties and the compensation scheme offered to the managers. Such an approach is of much greater economic appeal, as it is incentive-based and so less prescriptive. But, this paper argues that there is a trade off. The use of incentives by the new approach implies that a whole host of strategic interactions in the bank are relevant in evaluating its effectiveness. This aspect of a soft-link regulation such as PCA seems to have received little attention. We attempt to clarify the precise nature of the trade-off by analysing two potential sources of distortion: agency and reputational. In the context of a simple principle-agent model, the paper studies incentives generated by PCA on managerial risk-taking when the level of risk is not directly contractable. We identify contexts in which a distortion might arise. Second, it studies the effect of reputational concerns under public disclosure of a breach. The paper shows that this might lead to a perverse pattern in the relative size of the trading activities compared with the size of bank as a whole. A hard-link approach avoids such distortions. The results form a first step towards modifying PCA to construct optimal incentive-compatible regulatory schemes. How PCA might be modified to rectify the distortions identified here, is discussed informally.