Managerial Overconfidence and Bank Bailouts

Empirical evidence suggests that managerial overconfidence and government guarantees contribute substantially to excessive risk-taking in the banking industry. This paper incorporates managerial overconfidence and limited bank liability into a principal-agent model, where the bank manager unobservably chooses the level of risk. An overconfident manager overestimates the returns to risk. Our main result is that managerial overconfidence necessitates an intervention into banker pay. This is due to the bank's exploitation of the manager's overvaluation of bonuses, which causes excessive risk-taking in equilibrium and is amplified by government guarantees. Moreover, we show that an optimal bonus tax rises in overconfidence, if returns to risk-taking are positive. Finally, the model indicates that overconfident managers are more likely to be found in banks with large government guarantees, low bonus taxes, and lax capital requirements.