Distorted Risk Incentives from Size Threshold-Based Regulations

Abstract

Many regulations 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 risk around the Dodd-Frank Act, a major regulation with size thresholds. We provide empirical evidence that is consistent with the main predictions of the model.

Keywords: Risk incentives, Regulation, Size thresholds, Size contingent regulation, Dodd-Frank, Regulatory distortion, risk taking

JEL Classification: G18, G28, D21, D22