Distorted Risk Incentives from Size Threshold-Based Regulations

Abstract

Many regulations that affect firms and banks in the economy are based on size thresholds. We develop a model that shows that such regulations distort risk-taking incentives, providing above-threshold firms with greater incentives to take risk and below-threshold firms the opposite. Risk distortion varies nonlinearly as a function of the distance from the size threshold, and is increasing in the magnitude of the regulatory costs. We test our model by examining changes in bank risk around the Dodd-Frank Act, a major banking regulation with size thresholds. We provide empirical evidence that supports the main predictions of the model.

Keywords: Regulation, Risk incentives, Size thresholds, Size contingent regulation, Dodd-Frank

JEL Classification: G12, G18, G21, G28, G32