Incentive-Based Capital Requirements

Abstract

This paper proposes a new regulatory approach that implements capital requirements contingent on executive incentive schemes. We argue that excessive risk taking in the financial sector originates from the shareholder moral hazard created by government guarantees rather than from corporate governance failures within banks. The idea behind the proposed regulatory approach is thus that the more the compensation structure decouples the interests of bank managers from those of shareholders by curbing risk-taking incentives, the higher the leverage the bank is permitted to take on. Consequently, the risk-shifting incentives caused by government guarantees and the risk-mitigating incentives created by the compensation structure offset each other such that the manager chooses the socially efficient investment policy. This paper was accepted by Amit Seru, finance.

Optimal pay regulation for too-big-to-fail banks

“…The bank owner's first best project choice rule is given by (Owner FB). In these variables, (2) can be rewritten using (3) and (5) to give the regulator's first best project choice rule: the high risk project only being selected if the resultant market capitalisation satisfies:…”

“…It also notes that JP Morgan Chase recovered more than US$100 million of compensation through the firm's clawback mechanisms from individuals linked to the 2012 London Whale incident, in which its Chief Investment Office generated a trading loss initially estimated to be US$2 billion through derivative transactions. 5 In the theoretical analysis below, we refer to all forms of ex post pay adjustment as 'clawback' as a shorthand. We first demonstrate that if banks are required by the regulator to implement a clawback mechanism, and they restrict themselves to using equity-based pay, then the clawback regulation will reduce the bank executive's risk-taking incentives.…”

“…Hakenes and Schnabel study a model in which a bank can produce one of three possible return realisations, and such that an optimising 6 An alternative approach pursued is to link pay regulations to capital regulations and the price of deposit insurance. Papers in this vein include John, Saunders and Senbet (2000), Freixas and Rochet (2013), Hilscher, Landskroner and Raviv (2016), and Eufinger and Gill (2016).…”

“…Under a clawback regime with parameter p, if the bank restricts to equity based pay then Proposition 3 proved that the executive's decision rule becomes select the high volatility project if (1 − δ (1 − χ) p) K H > K L . Returning to (r, Z) space using (3) and(5), this decision rule to select the high volatility project is(1 − δ (1 − χ) p) (1 + D) Z − λDχ χ + µ (1 − χ) − (1 − λ) χDi −1 > (1 + D) r−λD−(1 − λ) Di −1…”

“…See FSB (2014), section 2 4. See FSB (2015), page 13 5. The Financial Times report that the trading loss was subsequently revised up to US$6.2 billion.…”