On Bankers and Their Incentives

I model the principal-agent problem in a banking context, where the agent must not only be induced to exert costly unveri…able e¤ort but also to exercise …duciary discretion in lending money on behalf of an employing bank. I show that the spread in wage outcomes necessary to induce …duciary discretion may be prohibitively expensive; instead, the bank may opt for a second-best solution where excessively risky loans are tolerated. I then show how universal banking, i.e., combining lending with investment banking, a¤ects the basic result. On the one hand, the bank may be able to use the investment banking activities to monitor agent e¤ort. However, where this is impossible, the cost of inducing …duciary discretion rises, because the necessary spread in wage outcomes is wider. In response, the bank may either forgo the universal form or adopt it but assume a more risk-seeking posture than would a pure lender. Finally, I consider banking competition and show that the greater the number of banks competing to lend to a group of borrowers, the more expensive it is to induce …duciary discretion in agent behavior and thus the riskier the banking system becomes.