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.

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.

The practice of resetting strike prices on underwater executive stock options has drawn criticism for weakening managerial incentives. Our model shows that although the anticipation of resetting can negatively affect initial incentives, resetting can still be an important, value-enhancing aspect of compensation contracts, even from an ex-ante standpoint. In fact, we find that some resetting is almost always optimal. The relative advantages of resetting diminish with greater ability of managers to influence the resetting process, greater relative importance of external factors on stock performance, and lower costs of replacing incumbent managers.