Abstract
We analyze the limits of regulating bank CEO compensation to reduce risk shifting in the presence of an active board that retains the right to approve new investment strategies. Compensation regulation prevents overinvestment in strategies that increase risk, but it is ineffective in preventing underinvestment in strategies that reduce risk. The regulator optimally combines compensation and capital regulations. In contrast, if the board delegates the choice of strategy to the CEO, compensation regulation is sufficient to prevent both types of risk shifting. Compensation regulation increases shareholders’ incentives to implement an active board, which reduces the effectiveness of compensation regulation.
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