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Rev Fin 2000; 13:95-125
© 2000 the Society for Financial Studies

Article

A theory of bank regulation and management compensation

K John1,z, A Saunders1 and LW Senbet2
1 Stern School of Business, New York University, Finance Department, 44 West 4th St. Suite 9-190, New York, NY 10012, USA
2 University of Maryland, USA
z Corresponding author
E-mail: kjohn@stern.nyu.edu

Abstract

We show that concentrating bank regulation on bank capital ratios may be ineffective in controlling risk taking. We propose, instead, a more direct mechanism of influencing bank risk-taking incentives, in which the FDIC insurance premium scheme incorporates incentive features of top-management compensation. With this scheme, we show that bank owners choose an optimal management compensation structure that induces first-best value-maximizing investment choices by a bank's management. We explicitly characterize the parameters of the optimal management compensation structure and the fairly priced FDIC insurance premium in the presence of a single or multiple sources of agency problems.


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