Risky Investments with Limited Commitment

Abstract

Over the last three decades there has been a dramatic increase in the size of the financial sector and in the compensation of financial executives. This increase has been associated with greater risk-taking and the use of more complex financial instruments. Parallel to this trend, the organizational structure of the financial sector has changed with the traditional partnership replaced by public companies. The organizational change has increased the competition for managerial talent, which may have weakened the commitment between investors and managers. We show how increased competition and the weaker commitment can raise the managerial incentives to undertake risky investment. In the general equilibrium, this change results in higher risk-taking, a larger and more productive financial sector with greater income inequality (within and across sectors), and a lower market valuation of financial institutions.