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Document Type

Article

Abstract

How do we prevent financial institutions from taking excessive risk when the public fisc serves as creditor? This is one of the central questions left over after the recent financial crisis and, for the past five years, there has been no shortage of proposed answers. Two of the more popular candidates for ex ante regulation—proprietary trading restrictions and enhanced capital requirements—are on their way to being enacted in one form or another, albeit with some controversy over their cost and ultimate efficacy. Meanwhile, a third, more indirect approach has sprouted in the pages of law and finance journals under which bank managers’ compensation packages would be adjusted to include bank debt, thereby altering their risk-taking incentives. This approach has even been put in place at certain non-U.S. financial institutions. This Article offers a critical appraisal of regulating bank risk-taking through executive pay design. “Risk regulation by pay” is less likely to ameliorate risk-taking than more direct approaches because bank managers with career concerns will continue to face significant incentives to take on high levels of firm risk. Moreover, regulating by pay is an inapt solution where marginal monitoring costs for creditors are relatively low as is the case with bank monitoring. Instead, the case for regulating bank risk through pay redesign must be grounded in a pessimistic view of regulator agency costs in a system of prudential regulation. It is hard, however, to see how compromised regulators faced with broad discretion would be much better at implementing a pay regulation regime. Thus, the most effective version of risk regulation by pay will be afflicted with largely the same implementation problems as traditional, direct risk regulation. Even worse, the very fact of risk regulation by pay, no matter how modestly proposed, makes it more likely that traditional direct monitoring will further atrophy, leaving the government-as-creditor worse off than before.

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