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http://ssrn.com/abstract=2019714
 
 

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A Regulator's Exercise of Career Option to Quit and Join a Regulated Firm's Management with Applications to Financial Institutions


Godfrey Cadogan


Ryerson University - Ted Rogers School of Management, Institute for Innovation and Technology Management; University of Cape Town -Research Unit in Behavioural Economics and Neuroeconomics (RUBEN), Faculty of Commerce - School of Economics

John A. Cole


North Carolina Agricultural & Technical State University - School of Business & Economics

August 1, 2012

Proceedings of Academy of Behavioral Finance & Economics, 2012

Abstract:     
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

working papers series


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Date posted: March 11, 2012 ; Last revised: August 2, 2012

Suggested Citation

Cadogan, Godfrey and Cole, John A., A Regulator's Exercise of Career Option to Quit and Join a Regulated Firm's Management with Applications to Financial Institutions (August 1, 2012). Proceedings of Academy of Behavioral Finance & Economics, 2012. Available at SSRN: http://ssrn.com/abstract=2019714 or http://dx.doi.org/10.2139/ssrn.2019714

Contact Information

Godfrey Cadogan (Contact Author)
Ryerson University - Ted Rogers School of Management, Institute for Innovation and Technology Management ( email )
575 Bay
Toronto, Ontario M5G 2C5
Canada
University of Cape Town -Research Unit in Behavioural Economics and Neuroeconomics (RUBEN), Faculty of Commerce - School of Economics ( email )
Rondebosch, 7701
South Africa
John A. Cole
North Carolina Agricultural & Technical State University - School of Business & Economics ( email )
Merrick Hall
Greensboro, NC 27411
United States
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