Regulating Risk and Governance in Banks: A Contractarian Perspective

Abstract:     
In the lead up to the 2007–2008 financial crisis, U.S. banks engaged in systemic, excessive risk taking that drove the economy to the verge of collapse. This Article makes three contributions to understanding how this pandemic of excessive bank risk taking was possible and which policy reforms are desirable to promote more prudent banking conduct.

First, this Article counters the common narrative that blames the crisis on managerial moral hazard. Instead, it focuses on bank shareholders and debtholders, arguing that their distorted incentives drove banks to take excessive risks. Corporate finance theory teaches that debtholders charge higher interest rates in response to the shareholders’ preferences for high-risk, high-return projects. In highly leveraged firms, this incentivizes shareholders, eager to minimize the cost of debt, to seek safe governance arrangements that can commit their firms to sound risk choices. But in the banking sector, deposit insurance and bailouts undermine this balance, causing debtholders to become less sensitive to risk taking. As a result, bank shareholders, shielded by limited liability and unconstrained by debtholder monitoring, rationally support governance arrangements that incentivize risk taking.

This Article’s second contribution is normative: it develops a contractarian approach to bank regulation in order to overcome the distortions that affect bank governance. Under this approach, regulators should assume the hypothetical position of bank debtholders in a world without safety nets, and they should discipline banks as debtholders would in such a world. Where debtholders would offer lower interest rates in exchange for safer governance, regulators would offer lower capital requirements and lower deposit insurance premiums while demanding the same governance concessions. By promoting more socially responsible risk taking, this policy reform would add to bank safety and overall economic stability.

Finally, this Article provides a conceptual foundation for designing and implementing safe governance arrangements in banks.

Number of Pages in PDF File: 81

Keywords: bank regulation, regulating risk, debtholders, shareholders, safe governance, risk taking, contractarian approach

Accepted Paper Series