DP11380 Bank Regulation, CEO Compensation, and Boards

Author(s): Julian Kolm, Christian Laux, Gyöngyi Lóránth
Publication Date: July 2016
Keyword(s): Bank Regulation, corporate governance, Executive compensation
JEL(s): G21, G28
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11380

We analyze the limits of regulating bank CEO compensation to reduce risk shifting in the presence of an active board that retains the right to approve new investment strategies. Compensation regulation prevents overinvestment in strategies that increase risk, but it is ineffective in preventing underinvestment in strategies that reduce risk. The regulator optimally combines compensation and capital regulations. In contrast, if the board delegates the choice of strategy to the CEO, compensation regulation is sufficient to prevent both types of risk shifting. Compensation regulation increases shareholders' incentives to implement an active board, which reduces the effectiveness of compensation regulation.