Optimal Regulation, Executive Compensation and Risk Taking by Financial Institutions
60 Pages Posted: 7 Mar 2015 Last revised: 6 Apr 2020
Date Written: April 2, 2020
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: Suggested Citation