Abstract
We present an equilibrium model of financial institutions to examine the optimal regulation of risk taking. Shareholders provide incentives for 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. 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 there are frictions – if enforcement is limited, if there is uncertainty about the incentives facing management and costs of risk shifting, or if regulation cannot be bank specific – welfare can be improved by employing both policy tools.
| Original language | English |
|---|---|
| Article number | 102104 |
| Journal | Journal of Corporate Finance |
| Volume | 71 |
| DOIs | |
| State | Published - Dec 2021 |
Bibliographical note
Publisher Copyright:© 2021 Elsevier B.V.
Funding
We are grateful to seminar participants at the Bank of Israel, Bar Ilan University, Ben-Gurion University, Hebrew University, Tel Aviv University, F.E.B.S. annual meeting (2014), FMA annual meeting (Nashville, 2014), FIRS annual meeting (Reykjavik, 2015), Spring meeting of the MFS society (2015), Basel workshop on credit risk (2015), as well as to two anonymous referees, Doron Avramov, Allen Berger, Ravel Jabbour, Clemens Otto, Marco Pagano, Zvi Wiener, and Han Xia for useful comments. Raviv acknowledges support from the Raymond Ackerman Family Chair in Israeli Corporate Governance and the Israel Science Foundation (ISF) through grant number 2443/19. We are grateful to seminar participants at the Bank of Israel, Bar Ilan University, Ben-Gurion University, Hebrew University, Tel Aviv University, F.E.B.S. annual meeting (2014), FMA annual meeting (Nashville, 2014), FIRS annual meeting (Reykjavik, 2015), Spring meeting of the MFS society (2015), Basel workshop on credit risk (2015), as well as to two anonymous referees, Doron Avramov, Allen Berger, Ravel Jabbour, Clemens Otto, Marco Pagano, Zvi Wiener, and Han Xia for useful comments. Raviv acknowledges support from the Raymond Ackerman Family Chair in Israeli Corporate Governance and the Israel Science Foundation (ISF) through grant number 2443/19.
| Funders | Funder number |
|---|---|
| FIRS | |
| Bar-Ilan University | |
| Hebrew University of Jerusalem | |
| Israel Science Foundation | 2443/19 |
| Tel Aviv University | |
| Ben-Gurion University of the Negev |
Keywords
- Bank regulation
- Executive compensation
- Financial crises
- Financial institutions
- Risk taking