Optimal regulation, executive compensation and risk taking by financial institutions

Jens Hilscher, Yoram Landskroner and Alon Raviv

Journal of Corporate Finance, 2021, vol. 71, issue C

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.

Keywords: Bank regulation; Financial institutions; Executive compensation; Risk taking; Financial crises (search for similar items in EconPapers)
JEL-codes: G21 G28 (search for similar items in EconPapers)
Date: 2021
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:corfin:v:71:y:2021:i:c:s0929119921002261

DOI: 10.1016/j.jcorpfin.2021.102104

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