The Effect of Banking Deregulation on Borrowing Firms’ Risk-Taking Incentives

Posted: 9 Mar 2023

See all articles by Daniel A. Bens

Daniel A. Bens

INSEAD

Scott Liao

University of Toronto - Rotman School of Management

Barbara Su

Temple University - Fox School of Business and Management

Date Written: September 4, 2022

Abstract

We examine how regulatory restrictions on capital market activity affect the compensation contracting environment within firms. This study aims to expand our understanding of how financial market development affects firm risk-taking via management compensation designs. Specifically, taking advantage of the staggered implementation of the Interstate Banking and Branching Efficiency Act (IBBEA), which increases bank competition and loan geographical diversification, this study examines how borrowing firms’ compensation structures change when banks increase risk tolerance in their loan portfolios. Using hand-collected compensation data of firms with market capitalization less than $75 million, we hypothesize and find that borrowing firms are likely to increase risk incentives after IBBEA and that this increase is more pronounced for firms located in states with less banking competition in the pre-IBBEA period. We also show the findings to be more significant for borrowers whose lenders acquire more diversification benefits after IBBEA. These findings suggest that following deregulation, when banks face increased competition as well as an enhanced ability to diversify their credit risk geographically, these same banks tend to increase their tolerance for borrowers’ risk-taking. That is, their clients —nonfinancial firms borrowing from them—adjust their compensation contracts that are previously constrained by bank distaste for risk. We also document that firms that increase their risk incentives the most invest more in R&D, suggesting that management compensation is a complementary channel through which IBBEA affects firm innovation.

Keywords: banking, deregulation, risk-taking, compensation, IBBEA, innovation

Suggested Citation

Bens, Daniel A. and Liao, Wei-Yi (Scott) and Su, Barbara, The Effect of Banking Deregulation on Borrowing Firms’ Risk-Taking Incentives (September 4, 2022). Contemporary Accounting Research, Forthcoming, Available at SSRN: https://ssrn.com/abstract=4219108

Daniel A. Bens

INSEAD ( email )

Boulevard de Constance
77305 Fontainebleau Cedex
France

Wei-Yi (Scott) Liao (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Barbara Su

Temple University - Fox School of Business and Management ( email )

Philadelphia, PA 19122
United States

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