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.