Bank Capital Requirements and Managerial Self-Interest

Abstract

We analyze the effect of capital adequacy requirements on bank risk policy when managers and shareholders have different information about the quality of the loan portfolio. In a two-period model in which shareholders implement the optimal contract with managers, we show that the level of managerial effort (and therefore the quality of the loan portfolio) is higher when shareholders cannot observe the manager's action. When information regarding the bank loan portfolio is symmetric, capital requirements help reduce the excess risk-taking problem that deposit insurance creates. Taking as given optimal regulation on capital requirements and deposit insurance, we show that the moral hazard problem in banks leads to a reduction in the banks' loan portfolio through an increase in the managerial effort in loan supervision. Only high-quality loans are accepted by the bank, but some profitable investments are bypassed because managers are more interested in maximizing their compensation (diluting the stock value) than in maximizing the shareholders' wealth. Thus we conclude that the riskiness of banks may be suboptimally low under moral hazard. We show how bank debt can help alleviate this problem. Our results are related to the theoretical and empirical literature that deals with the effects of the Basle Accords on the banks' credit policy.