A Regulator's Exercise of Career Option to Quit and Join a Regulated Firm's Management with Applications to Financial Institutions

Abstract

Among the issues raised during post-mortem of the financial crisis of 2008 is regulatory capture and revolving doors for regulators and political operatives transitioning to lobbying firms or financial firms they once regulated. Several papers claim that this facilitated lax enforcement by regulators, and excessive risk taking by financial firms – key factors that led to the crisis. This paper fills a gap in the literature by posing the revolving door hypothesis in the context of managerial compensation, and labor market mobility, for regulators who design mechanism(s) that affect firm capital structure, and who subsequently exercise career options to quit and join firm management or a lobbying firm. Our theory predicts that regulatory signals embedded in firm capital structure provide a common thread between managerial compensation for former regulators, firm leverage, excessive volatility, and bankruptcy risk. We identify early warning signals for firm bankruptcy from critical time points in managerial stock option vega-leverage space. We find support for several aspects of our theory in a sample of US commercial banks. Data show that prior to the 2008 financial crisis, when the trend in average bank leverage and managerial compensation in commercial banks via stock option grants began to increase, high subprime interest rates on bank loans became tax deductible. Ex-regulators in their capacity as bank lobbyists induced tax revenue transfers which fueled financial institutions leverage and de facto banks’ managerial compensation. Furthermore, based on a sample of bank CEO vega between 1994 and 2006, our managerial vega-leverage theory predicts an out-of-sample critical time point in 2007, and a range of critical time points for commercial bank failures thereafter. So our model would have predicted the 2008 financial crisis.