Optimal Regulation, Executive Compensation and Risk Taking by Financial Institutions

60 Pages Posted: 7 Mar 2015 Last revised: 6 Apr 2020

See all articles by Jens Hilscher

Jens Hilscher

University of California, Davis

Yoram Landskroner

Hebrew University of Jerusalem - Department of Finance and Banking; New York University (NYU) - Leonard N. Stern School of Business

Alon Raviv

Bar-Ilan University - Graduate School of Business Administration

Date Written: April 2, 2020

Abstract

We present an equilibrium model of financial institutions to examine the optimal regulation of risk taking. Shareholders set compensation incentivizing management to increase risk to excessive levels. Regulators use caps on asset risk and compensation to achieve the socially optimal risk level. This level trades off costs of risk shifting and costs of bank default. We show that, without regulation, equilibrium risk lies above the optimal level. If information and enforcement are perfect, either policy tool (caps on asset risk or compensation) achieves the optimal risk level. If enforcement is limited, if there is uncertainty about the incentives facing management or costs of risk shifting, or if regulation cannot be bank specific, welfare can be improved by employing both policy tools.

Keywords: bank regulation; fnancial institutions; executive compensation; risk tak- ing; fnancial crises.

JEL Classification: G21, G28

Suggested Citation

Hilscher, Jens and Landskroner, Yoram and Raviv, Alon, Optimal Regulation, Executive Compensation and Risk Taking by Financial Institutions (April 2, 2020). Available at SSRN: https://ssrn.com/abstract=2574404 or http://dx.doi.org/10.2139/ssrn.2574404

Jens Hilscher

University of California, Davis ( email )

One Shields Avenue
Apt 153
Davis, CA 95616
United States

Yoram Landskroner

Hebrew University of Jerusalem - Department of Finance and Banking ( email )

Mount Scopus
Jerusalem, 91905
Israel

New York University (NYU) - Leonard N. Stern School of Business ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States

Alon Raviv (Contact Author)

Bar-Ilan University - Graduate School of Business Administration ( email )

The Graduate School of Business Administration
Ana and Max Web st
Ramat Gan
Israel

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