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

  • Arupratan Daripa
  • Simone Varotto

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.

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Paper provided by Bank of England in its series Bank of England working papers with number 69.

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Date of creation: Oct 1997
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Handle: RePEc:boe:boeewp:69
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  1. Tim S. Campbell & Yuk-Shee Chan & Anthony M. Marino, 1990. "An incentive based theory of bank regulation," Proceedings, Federal Reserve Bank of San Francisco, issue Nov.
  2. Rochet, Jean-Charles, 1992. "Capital requirements and the behaviour of commercial banks," European Economic Review, Elsevier, vol. 36(5), pages 1137-1170, June.
  3. David Marshall & Subu Venkataraman, 1997. "Bank capital standards for market risk: a welfare analysis," Working Paper Series, Issues in Financial Regulation WP-97-09, Federal Reserve Bank of Chicago.
  4. Patricia Jackson & David Maude & William Perraudin, 1998. "Bank Capital and Value at Risk," Bank of England working papers 79, Bank of England.
  5. Paul H. Kupiec & James M. O'Brien, 1995. "The use of bank trading risk models for regulatory capital purposes," Finance and Economics Discussion Series 95-11, Board of Governors of the Federal Reserve System (U.S.).
  6. Besanko, David & Kanatas, George, 1996. "The Regulation of Bank Capital: Do Capital Standards Promote Bank Safety?," Journal of Financial Intermediation, Elsevier, vol. 5(2), pages 160-183, April.
  7. Chan, Yuk-Shee & Greenbaum, Stuart I & Thakor, Anjan V, 1992. " Is Fairly Priced Deposit Insurance Possible?," Journal of Finance, American Finance Association, vol. 47(1), pages 227-45, March.
  8. Paul H. Kupiec & James M. O'Brien, 1995. "A pre-commitment approach to capital requirements for market risk," Proceedings 475, Federal Reserve Bank of Chicago.
  9. Paul H. Kupiec & James M. O'Brien, 1995. "Recent developments in bank capital regulation of market risks," Finance and Economics Discussion Series 95-51, Board of Governors of the Federal Reserve System (U.S.).
  10. Edward S. Prescott, 1997. "The pre-commitment approach in a model of regulatory banking capital," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 23-50.
  11. Dimson, Elroy & Marsh, Paul, 1995. " Capital Requirements for Securities Firms," Journal of Finance, American Finance Association, vol. 50(3), pages 821-51, July.
  12. Paul H. Kupiec, 1995. "Techniques for verifying the accuracy of risk measurement models," Finance and Economics Discussion Series 95-24, Board of Governors of the Federal Reserve System (U.S.).
  13. Giammarino, R.M. & Sappington, D.E.M., 1990. "An Incentive Approach to Banking Regulation," Papers 367, California Davis - Institute of Governmental Affairs.
  14. Paul H. Kupiec & James M. O'Brien, 1997. "The pre-commitment approach: using incentives to set market risk capital requirements," Finance and Economics Discussion Series 1997-14, Board of Governors of the Federal Reserve System (U.S.).
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