Agency Incentives and Reputational Distortions

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 10 October 1997

Working Paper No. 69
By Arupratan Daripa and Simone Varotto

In regulating the market risk exposure of banks, the approach taken to date is to use a `hard-link' regime that sets a relation between exposure and capital
requirement exogenously. A new `pre-commitment' approach (PCA) proposes the use of a `soft-link'. Such a link is not externally imposed, but arises endogenously. Such an approach is of much greater economic appeal, as it is incentive-based and so less prescriptive.

But, we argue that there is a trade-off. The use of incentives by the new approach implies that a whole host of strategic interactions in the bank are relevant in evaluating its effectiveness. This aspect of a soft-link regulation such as PCA seems to have received little attention. We attempt to clarify the precise nature of the trade-off by analysing two potential sources of distortion: agency and reputational.

In the context of a simple principal-agent model, we study the incentives generated by PCA on managerial risk-taking when the level of risk is not directly
observable by the bank owner. We identify contexts in which a distortion might arise. Second, we study the effect of reputational concerns under public disclosure of a breach. We show that this might lead to a perverse pattern in the relative size of the trading activities compared with the size of bank as a whole. A hard-link approach avoids such distortions.

The results form a first step towards modifying PCA to construct optimal incentive-compatible regulatory schemes. We discuss informally how PCA might be modified to rectify the distortions identified here.

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