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

This article studies the disclosure of stress test results by a regulator who is privately informed about bank health when she chooses the stress scenario. I show that the regulator’s choice of the stress scenario depends on how heterogeneous health is across banks. There can be fewer runs than under transparency. However, there are more runs than when the regulator chooses the scenario before becoming informed, highlighting a time-inconsistency problem. Moreover, disclosure can become a source of informational contagion, as changes in the health of one bank affect beliefs about other banks. The model explains the empirical puzzle that a bank’s share price can fall even though it passes the stress test

Regulators often delegate monitoring to local supervisors, which can improve information collection, but can also lead to agency problems and capture. We document that following the closure of a US bank regulator’s field offices, the banks they previously supervised actively increased their risk of failure by distributing cash, increasing leverage, and lending more than similar banks at the same time and place. Supervisor proximity is a channel through which these effects operate. Our findings suggest that local supervision is an important part of regulation, as it facilitates collection of information imperfectly reflected in reported measures, and that switching from onsite to offsite supervision can increase bank risk

We estimate the willingness-to-pay to bypass a loan-to-value (LTV) cap. Our identification relies on exogenous variation in debt exempt from the LTV regulation that can only be used as a substitute for a personal mortgage. Our baseline estimate reveals that homebuyers pay 7.3 Swedish Kroner (SEK) to avoid 1 SEK of equity down payment. The supply of debt not part of the LTV calculation increased by approximately 50% within 2 years after the LTV regulation. Financially weaker households drive the results

We examine how cross-country differences in capital regulations shape the structure of global lending syndicates. Using globally syndicated loans extended by banks from forty-four countries, we find that strictly regulated banks participate more in syndicates originated by lead lenders facing less stringent capital regulations. The resulting lending syndicates extend loans to riskier borrowers, charge higher spreads, forego covenants more frequently, and incur higher default rates. Such syndication activity also facilitates the access to credit by riskier corporations and exposes both participants and lead arrangers to greater systemic risk. Overall, our finding is consistent with the explanation that strictly regulated banks rely on the expertise of loosely regulated banks to procure risky deals outside the border

This article studies the optimal design of bank capital regulations when capital markets are subject to adverse selection. I show how the implementation of capital requirements can eliminate the information frictions that make raising capital costly by screening banks to reveal their private information to the market. The optimal regulations induce information revelation via recapitalization programs when the banking sector is weak and pool the banks’ private information via uniform capital requirements otherwise. Optimal capital requirements are linked to the securities issued to meet them, demonstrating potential welfare gains from incorporating more and less informationally sensitive securities into the design of capital regulations. Finally, the analysis generates insights into the joint design of equity capital requirements and additional tier 1 capital securities

We investigate the motivations and effects of financial firms’ hiring of former US financial regulatory employees. The number of top executives with regulatory experience per firm has increased 24% over 2001–15, and hiring is associated with positive average announcement returns and a salary premium. In the quarter after hire, market and balance sheet measures of firm risk decrease significantly and measures of risk management activity increase, especially for hires from prudential regulators, who directly monitor financial firm risk. The absence of this result for unregulated firms and for exogenous shocks to regulatory experience suggests that firms hire ex-employees of their regulators when they perceive a need to reduce risk, consistent with a schooling hypothesis. We find little direct evidence of quid pro quo behavior in regulatory event frequency and fines

Before regulations were enacted to prevent such practices, information leaked through selective disclosure was incorporated into markets prior to the public release of news. “News days” did not deliver news to markets; now they do. We provide novel evidence of changes in returns and turnover behavior around the enactment of regulations barring selective disclosure practices in the United States and the EU. We conversely document lack of such changes in Australia and Japan, which did not implement similar measures. We conclude that selective disclosure resolves Roll’s R2 puzzle

Rapid growth of stablecoins has raised concerns about issuer default and spillover risks. To assess these risks, we model a stablecoin issuer facing persistent demand shocks. Absent regulation, the issuer holds little capital and favours interest-bearing but illiquid bonds over cash. This exposes coin-holders to default risk and poses spillovers via bond fire-sales. How can regulation mitigate these risks? Capital and liquidity thresholds can help, especially when introduced as usable buffers. The thresholds can be breached, providing flexibility. However, breaches trigger additional redemptions that discipline the issuer. The thresholds operate through asymmetric channels: the liquidity threshold raises only cash, whereas the capital threshold increases both capital and cash. Both thresholds mitigate default and spillover risks, making them substitutes when either risk is targeted separately but complements when both risks are targeted jointly. We provide a two-way mapping that helps derive capital-liquidity threshold combinations implied by chosen risk targets (and vice-versa

We investigate how liquidity regulations affect banks by examining a dormant monetary policy tool that functions as a liquidity regulation. For causal inference, we use a regression kink design that relies on the variation in a marginal high-quality liquid asset requirement around an exogenous threshold. We show that mandated increases in liquidity cause banks to reduce credit supply. Liquidity requirements also depress banks’ profitability, though some of the regulatory costs are passed on to liability holders. We document a prudential benefit of liquidity requirements by showing that banks subject to a higher requirement just before the financial crisis had lower odds of failure