Financial institutions prefer, even in the absence of supervisory prompting, to employ management and monitoring of risks. Recently, financial supervisors have codified this practice, and generally require financial institutions to measure their exposure to market risks with statistical models, specifically Value at–Risk (VaR) (see the Basel Committee, 1996). Under the latest Basel–II proposals, the same general methodology will be applied to measuring credit, operational, and eventually liquidity risk. In other words, statistical risk modelling (termed Internal Rating Based) will become the linchpin upon which the stability of the financial system rests. While the Internal Rating Based approach has been actively studied, one aspect has received little attention: Introducing regulation can augment the incentives for moral hazard when markets are incomplete, where such regulation could not have such effects when markets are complete. In this chapter we study the potential for moral hazard in the management and regulation of financial institutions’ risk.
We approach the topic from various directions. First, we analyze a bank’s choice of projects, followed by a bank’s choice of risk monitoring systems. Our objective is to document unintended consequences that may arise when a financial institution is subjected to external risk constraints, in particular the extent to which risk regulation helps in mitigating risk and the possibility that risk regulation may actually increase risk. This increase in risk, we argue, results from a combination of incomplete markets and moral hazard. It is well known that banks are subject to moral hazard whilst allocating funds due to implicit government guarantees which act as put options. Thus lending of last resort, deposit insurance, and capital adequacy regulations, among others all have been demonstrated to increase risk taking by banks. We augment this research area by studying the incentives for and effects of moral hazard when risk regulation is introduced in incomplete markets. We reach two main results regarding the effect of risk regulation on banks’ risk management through choice of projects.
First, we consider risk direct regulation where a risk-averse bank purchases insurance for a fair premium from a risk-neutral supervisor. We establish that the introduction of this insurance, even though fairly priced, induces moral hazard in the bank’s selection of projects, leading to excessive risk taking.
Second, we consider a setting where the introduction of regulation restricts the set of strategic decisions available to a bank. We establish that introducing such regulation that prohibits decisions that would not have been taken in the absence of regulation may, nonetheless, affect actual decision. Hence, even non–binding regulation can have real effects due to market incompleteness.
Third, we analyze the effect of regulation on banks’ choice of risk monitoring systems. In particular, we investigate the incentives that key parties have for accurately measuring risk, and the contractual relationship that binds the risk manager, the bank owner, and the regulatory supervisor. Our objective is to explicitly model how the imposition of financial risk regulation affects financial institutions preferences for different risk monitoring systems. To this end, we propose a principal–agent model of the relation between a bank’s risk manager and owners, in which the setting is complicated by the presence of regulators. Each bank can chose the quality of its risk monitoring system. We reach three conclusions regarding banks’ choice of risk monitoring system. First, we demonstrate in Proposition 3, that in the absence of regulatory supervision, financial institutions prefer the higher quality, finer system, if the direct costs of such a system are sufficiently low. Hence, the finer system implies first best outcomes while the coarser regime results in second best outcomes. Second, in Proposition 4, we demonstrate that the addition of supervision may cause the financial institutions to reverse this choice. In other words, within our model, financial risk regulation provides incentives for banks to implement a lower quality risk monitoring system than they would in the absence of regulation. Finally, when the supervisor decides to affect the implementation of the system, he affects asset volatility and hence (inadvertently) introduces procyclicality.
Download
Regulation Incentives for Risk Management in Incomplete Markets
