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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

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  • Arupratan Daripa
  • Simone Varotto

Abstract

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.

Suggested Citation

  • Arupratan Daripa & Simone Varotto, 1997. "Agency Incentives and Reputational Distortions: a Comparison of the Effectiveness of Value-at-Risk and Pre-commitment in Regulating Market Risk," Bank of England working papers 69, Bank of England.
  • Handle: RePEc:boe:boeewp:69
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    File URL: http://www.bankofengland.co.uk/archive/Documents/historicpubs/workingpapers/1997/wp69.pdf
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    References listed on IDEAS

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    1. 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.).
    2. David Marshall & Subu Venkataraman, 1999. "Bank Capital Standards for Market Risk: A Welfare Analysis," Review of Finance, European Finance Association, pages 125-157.
    3. David A. Marshall & Subu Venkataraman, 1997. "Bank capital standards for market risk: a welfare analysis," Proceedings 547, Federal Reserve Bank of Chicago.
    4. 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.
    5. 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.).
    6. 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 227-245, March.
    7. Giammarino, Ronald M & Lewis, Tracy R & Sappington, David E M, 1993. " An Incentive Approach to Banking Regulation," Journal of Finance, American Finance Association, vol. 48(4), pages 1523-1542, September.
    8. 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.).
    9. Edward Simpson 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.
    10. Patricia Jackson & David Maude & William Perraudin, 1998. "Bank Capital and Value at Risk," Bank of England working papers 79, Bank of England.
    11. Dimson, Elroy & Marsh, Paul, 1995. " Capital Requirements for Securities Firms," Journal of Finance, American Finance Association, vol. 50(3), pages 821-851, July.
    12. Bekaert, Geert & Hodrick, Robert J. & Marshall, David A., 2001. "Peso problem explanations for term structure anomalies," Journal of Monetary Economics, Elsevier, vol. 48(2), pages 241-270, October.
    13. Hoover, Kevin D & Sheffrin, Steven M, 1992. "Causation, Spending, and Taxes: Sand in the Sandbox or Tax Collector for the Welfare State?," American Economic Review, American Economic Association, pages 225-248.
    14. Besanko, David & Kanatas, George, 1996. "The Regulation of Bank Capital: Do Capital Standards Promote Bank Safety?," Journal of Financial Intermediation, Elsevier, pages 160-183.
    15. Campbell, Tim S. & Chan, Yuk-Shee & Marino, Anthony M., 1992. "An incentive-based theory of bank regulation," Journal of Financial Intermediation, Elsevier, pages 255-276.
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    17. Rochet, Jean-Charles, 1992. "Capital requirements and the behaviour of commercial banks," European Economic Review, Elsevier, pages 1137-1170.
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    Citations

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    Cited by:

    1. Alistair Milne & A Elizabeth Whalley, 1999. "Bank capital and risk taking," Bank of England working papers 90, Bank of England.
    2. Rochet, Jean-Charles, 1999. "Solvency regulations and the management of banking risks," European Economic Review, Elsevier, pages 981-990.
    3. Jezabel Couppey, 2000. "Vers un nouveau schéma de réglementation prudentielle : une contribution au débat," Revue d'Économie Financière, Programme National Persée, vol. 56(1), pages 37-56.
    4. Jean-Marc Figuet, 2000. "Le prêteur en dernier ressort international," Revue d'Économie Financière, Programme National Persée, vol. 56(1), pages 57-75.
    5. João A. C. Santos, 2000. "Bank capital regulation in contemporary banking theory: a review of the literature," BIS Working Papers 90, Bank for International Settlements.

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