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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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    References listed on IDEAS

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    7. 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.).
    8. 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.
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    Cited by:

    1. Rochet, Jean-Charles, 1999. "Solvency regulations and the management of banking risks," European Economic Review, Elsevier, vol. 43(4-6), pages 981-990, April.
    2. 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.
    3. Alistair Milne & A Elizabeth Whalley, 1999. "Bank capital and risk taking," Bank of England working papers 90, Bank of England.
    4. Jézabel Couppey, 2000. "Vers un nouveau schéma de réglementation prudentielle : une contribution au débat," Cahiers de la Maison des Sciences Economiques bla00006, Université Panthéon-Sorbonne (Paris 1).
    5. 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.
    6. Jean-Marc Figuet, 2000. "Le prêteur en dernier ressort international," Revue d'Économie Financière, Programme National Persée, vol. 56(1), pages 57-75.
    7. Casellina, Simone & Pandolfo, Giuseppe & Quagliariello, Mario, 2020. "Applying the Pre-Commitment Approach to bottom-up stress tests: A new old story," Journal of Economics and Business, Elsevier, vol. 112(C).

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