Optimal Regulation, Executive Compensation and Risk Taking by Financial Institutions
55 Pages Posted: 7 Mar 2015 Last revised: 19 Nov 2017
Date Written: November 18, 2017
We present an equilibrium model of financial institutions in which we examine the optimal regulation of risk taking. Shareholders set compensation to create incentives for management to choose excessive risk levels. To prevent such high levels, regulators use caps on asset risk (traditional bank supervision) and on pay (regulation of compensation) to achieve the socially optimal level of risk. We show that (1) without regulation, equilibrium risk will be higher than the optimal social level; (2) socially optimal risk is procyclical; (3) if there is perfect information using either policy tool can achieve the optimal level of risk; (4) if enforcement is limited or information is asymmetric, direct bank supervision is the more robust policy tool, though social 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: Suggested Citation