A Regulator's Exercise of Career Option to Quit and Join a Regulated Firm's Management with Applications to Financial Institutions
UCT - School of Economics; Ryerson University - Ted Rogers School of Management, Institute for Innovation and Technology Management
John A. Cole
North Carolina Agricultural and Technical State University - School of Business & Economics
August 1, 2012
Proceedings of Academy of Behavioral Finance & Economics, 2012
We introduce a behavioral model of managerial compensation, in context of labor market mobility,for regulators who design mechanism(s) that affect ﬁrm capital structure, and then cash in later by exercising a career option to join ﬁrm management or a consultancy. Our model derives several new results. First, we prove that regulator signals embedded in capital structure induce discrete regimes for the ﬁrm’s pricing strategy. Agency cost comprises regulator substitution of ﬁrm proﬁt for consumer welfare to increase the value of her career option. Second, we prove that the internal rate of return (IRR) on ﬁrm projects involving a former regulator is linear in weighted average cost of capital and her human capital beta. So human capital is an omitted variable in IRR estimates based solely on net present value. Third, we prove that the value of a regulator’s career option increases with ﬁrm leverage. So regulator’s have career incentives to embed leverage inducing regulatory signals in the ﬁrm’s capital structure. And ﬁrms have proﬁt incentives to hire former regulators to increase IRR. This symbiotic relationship explains why strategically levered ﬁrms obtain better regulatory outcomes. Fourth, SheppGuo vega (price-risk sensitivity) relative to Black-Scholes-Merton vega for regulator career option on regulated ﬁrms, indicate that ﬁrm value-at-risk, i.e. tail risk and bankruptcy, is greater than it would be in non-regulatory capture regimes. Whereupon we identify warning signals for ﬁrm bankruptcy. We ﬁnd support for several aspects of our theory in a sample of US commercial banks. For example, data show that prior to the 2008 crisis, when the trend in average bank leverage and managerial compensation in commercial banks began to increase, high interest rates on bank loans became tax deductible. So wilily nilly legislators qua regulators effectively orchestrated tax revenue transfers to capitalize ﬁnancial institutions leverage and de facto bank manager compensation.
Number of Pages in PDF File: 56
Keywords: career option, revolving door, signalling, mechanism design, capital structure, leverage, IRR, WACC, beta pricing, vega, managerial compensation
JEL Classification: C02, D60, D81-82, G13, G18, G38, J24, J44, J45, L51
Date posted: March 11, 2012 ; Last revised: August 2, 2012
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