A Theory of Bank Regulation and Management Compensation

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Abstract
We show that concentrating bank regulation on bank capital ratios may be ineffective in controlling risk taking. We propose, instead, a more direct mechanism of influencing bank risk-taking incentives, in which the FDIC insurance premium scheme incorporates incentive features of top-management compensation. With this scheme, we show that bank owners choose an optimal management compensation structure that induces first-best value-maximizing investment choices by a bank's management. We explicitly characterize the parameters of the optimal management compensation structure and the fairly priced FDIC insurance premium in the presence of a single or multiple sources of agency problems. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies. (This abstract was borrowed from another version of this item.)

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