Pay as Risk Regulation

Abstract

How do we prevent financial institutions from taking excessive risk when the public fisc serves as their ultimate creditor? This is one of the central questions left over after the recent financial crisis and, for the past five years, there has been no shortage of proposed answers. Two of the more popular candidates for ex ante regulation – proprietary trading restrictions and enhanced capital requirements – are on their way to being enacted in one form or another, albeit with some controversy over their cost and ultimate efficacy. Meanwhile, a third, more indirect approach has been touted under which bank managers’ compensation packages would be adjusted to include bank debt thought to alter their risk preferences. This approach has even been adopted at certain non-U.S. financial institutions. This Article offers a critical appraisal of regulating bank risk-taking through executive pay design. "Regulation by pay" is less likely to ameliorate risk-taking because bank managers with career concerns will continue to face significant incentives to take on high levels of firm risk. Moreover, regulating by pay is an inapt solution where marginal monitoring costs for the government are relatively low as is the case given the existing bank monitor regime. Instead, the case for regulating bank risk through pay redesign is best grounded in a pessimistic view of regulator agency costs. It is hard, however, to see how compromised regulators, given broad discretion, would be much better at implementing a pay regulation regime. Even worse, the very fact of risk regulation by pay, no matter how modestly proposed, makes it more likely that traditional direct monitoring will further atrophy, potentially leaving the government-as-creditor worse off.

Keywords: executive compensation, inside debt, bank risk

JEL Classification: G2, G21, G3, G30, G34, J30, J33, K22, M51, M52