A Theory of Bank Regulation and Management Compensation

Abstract

This paper examines the incentive structure underlying the current features of bank regulation, particularly the role of prompt corrective action, capital requirements and mandatory restrictions on asset choice as primary tools to control risk-shifting incentives of depository institutions. We show that capital regulation has limited effectiveness, given the observed high leverage ratios of banks. We propose instead a more direct and effective mechanism of influencing incentives through the role of top-management compensation, whereby a fair and revenue-neutral FDIC premium incorporates incentive features of top-management compensation as well as the level of bank capitalization. With this pricing scheme (for FDIC insurance) we show that bank owners choose an optimal management compensation structure which induces first-best value-maximizing investment choices by a bank s management. We also characterize the parameters of the optimal managerial compensation structure and the FDIC premium schedule explicitly.