Regulatory risk management in commercial banking: An empirical investigation of agency theory

This study presents empirical tests of the joint impact of required capital and management incentive compensation on risk-taking in banking. Two separate branches of the extant literature are unified in this paper. The first branch holds that moral hazard associated with government-backed deposit insurance dictates the use of mandatory minimum capital requirements for commercial banks. The second branch argues that incentive compensation aligns the interests of managers and shareholders thus overcoming the inclination of managers to minimize risk at the expense of shareholder value. We employ a simultaneous equation model to mitigate the endogeneity between risk and the independent variables. The 1988 Basle Capital Accord is recognized as an exogenous shock to the capital ratios of commercial banks while CEO age and tenure are used as instruments for management compensation. The results consistently show a statistically significant negative coefficient on capital and a statistically significant positive coefficient on pay-performance sensitivity.