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Working Paper
Caught between Scylla and Charybdis? Regulating bank leverage when there is rent seeking and risk shifting
Banks face two moral hazard problems: asset substitution by shareholders (e.g., making risky, negative net present value loans) and managerial rent seeking (e.g., investing in inefficient ?pet? projects or simply being lazy and uninnovative). The privately-optimal level of bank leverage is neither too low nor too high: It balances effi ciently the market discipline imposed by owners of risky debt on managerial rent-seeking against the asset-substitution induced at high levels of leverage. However, when correlated bank failures can impose significant social costs, regulators may bail out bank ...
Journal Article
Introduction
This volume of the Economic Policy Review, "Special issue on the economic effects of September 11," explores some of the key economic consequences of the attacks of September 11. The six articles that make up the volume address several important questions: how great were the losses in New York City on September 11 and in the difficult months thereafter? How much will the nation spend to prevent future attacks? Did the destruction of information and infrastructure impair the functioning of the payments and securities settlement systems, and what steps minimize further damage? Will these ...
Journal Article
The effect of employee stock options on the evolution of compensation in the 1990s
Between 1995 and 1998, actual growth in compensation per hour (CPH) accelerated from approximately 2 percent to 5 percent. Yet as the labor market continued to tighten in 1999, CPH growth unexpectedly slowed. This article explores whether this aggregate "wage puzzle" can be explained by changes in the pay structure?specifically, by the increased use of employee stock options in the 1990s. The CPH measure captures these options on their exercise date, rather than on the date they are granted. By recalculating compensation per hour to reflect the options' value on the grant date, the ...
Report
Caught between Scylla and Charybdis? Regulating bank leverage when there is rent seeking and risk shifting
We consider a model in which banking is characterized by asset substitution moral hazard and managerial underprovision of effort in loan monitoring. The privately optimal bank leverage efficiently balances the benefit of debt in providing the discipline to ensure that the bank monitors its loans against the benefit of equity in attenuating asset-substitution moral hazard. However, when correlated bank failures impose significant social costs, regulators bail out bank creditors. Anticipation of this action generates multiple equilibria, including an equilibrium featuring systemic risk, in ...
Journal Article
Robust capital regulation
Regulators and markets can find the balance sheets of large financial institutions difficult to penetrate, and they are mindful of how undercapitalization can create incentives to take on excessive risk. This study proposes a novel framework for capital regulation that addresses banks' incentives to take on excessive risk and leverage. The framework consists of a special capital account in addition to a core capital requirement. The special account would accrue to a bank's shareholders as long as the bank is solvent, but would pass to the bank's regulators?rather than its creditors?if the ...
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The effect of employee stock options on bank investment choice, borrowing, and capital
In this paper, we test the hypothesis that granting employee stock options motivates CEOs of banking firms to undertake riskier projects. We also investigate whether granting employee stock options reduces the bank's incentive to borrow while inducing a buildup of regulatory capital. Using a sample of 549 bank-years for publicly traded banks from 1992 to 2002, we find some evidence that the bank's equity volatility (total as well as residual) and asset volatility increase as CEO stock option holdings increase. In addition, it appears that granting employee stock options motivates banks to ...
Report
Regulation, subordinated debt, and incentive features of CEO compensation in the banking industry
We study CEO compensation in the banking industry by considering banks? unique claim structure in the presence of two types of agency problems: the standard managerial agency problem and the risk-shifting problem between shareholders and debtholders. We empirically test two hypotheses derived from this framework: that the pay-for-performance sensitivity of bank CEO compensation (1) decreases with the total leverage ratio and (2) increases with the intensity of monitoring provided by regulators and nondepository (subordinated) debtholders. We construct an index of the intensity of outsider ...
Report
Corporate governance of financial institutions
We identify the tension created by the dual demands of financial institutions to be value-maximizing entities that also serve the public interest. We highlight the importance of information in addressing the public?s desire for banks to be safe yet innovative. Regulators can choose several approaches to increase market discipline and information production. First, they can mandate information production outside of markets through increased regulatory disclosure. Second, they can directly motivate potential producers of information by changing their incentives. Traditional approaches to bank ...