Executive Compensation, Supervisory Incentives, and Banking Regulation

This paper analyzes the optimal design of banking regulation when three layers of agency conflicts between society and banks, society and supervisors, and bank owners and managers are present. We argue that regulatory rules, supervisory incentives, and managerial compensation form an interdependent nexus. Since managerial incentives reveal information about banks’ operating policies comprehensive regulatory schemes can limit the scope for regulatory capture, enhance the power of supervisory incentives, and ultimately minimize banks’ risk-shifting incentives. In fact, the interaction of public and private agency conflicts improves overall risk-taking by banks to the benefit of society at large. We distill lessons for regulatory design and show that there exist tradeoffs between regulatory incentives and investments in institutional development.