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Optimal Regulation, Executive Compensation and Risk Taking by Financial Institutions

55 Pages Posted: 7 Mar 2015 Last revised: 19 Nov 2017

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: November 18, 2017

Abstract

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

Hilscher, Jens and Landskroner, Yoram and Raviv, Alon, Optimal Regulation, Executive Compensation and Risk Taking by Financial Institutions (November 18, 2017). 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
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
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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