Excessive Risk-taking Research Articles

Moral Hazard and the deposit insurance cap: a case study of Northern Rock and Silicon Valley Bank

ABSTRACT The main contention of this article is that government insurance for bank deposits should be unlimited. In spite of claims made in the literature concerning the moral hazard dangers of deposit insurance schemes, I argue that these claims are unconvincing; indeed, the empirical record - discussed here in relation to Northern Rock and SVB - demonstrates that uninsured depositors exhibit similar behaviour to their insured counterparts, undermining the claim that limiting insurance induces risk-monitoring. In contrast, there is strong evidence that in developed jurisdictions with established, mature regulatory institutions, deposit insurance does not result in excessive risk-taking on the part of banks. The significant financial stability benefits accruing to insuring bank deposits include the elimination of depositor runs, a reduction in the incentives for unregulated bank-like financial intermediation (shadow banking), and heightened competition. Activity restrictions and other measures can reduce any heightened risk-taking which emerges as a result of wider insurance coverage.

CORPORATE GOVERNANCE REFORMS IN THE BANKING SECTOR: ENHANCING STABILITY AND PROTECTING DEPOSITORS& INTERESTS

The global financial crisis of 2008 exposed significant weaknesses in the corporate governance practices of banks, leading to excessive risk-taking, lack of oversight, and eventual failures. In response, corporate governance reforms have been implemented in the banking sector to enhance stability, restore public confidence, and protect the interests of depositors. Effective corporate governance ensures that banks are managed responsibly, aligning the interests of various stakeholders. Key areas of focus for these reforms include board composition and effectiveness, risk governance and management, remuneration policies, internal controls and auditing, transparency and disclosure, and stakeholder engagement. Reforms emphasize the importance of having a diverse and independent board, robust risk management frameworks, aligning executive compensation with long-term performance, strengthening internal controls and auditing processes, enhancing transparency and disclosure requirements, and engaging with stakeholders, including depositors. Initiatives such as the Basel Committee on Banking Supervision's guidelines and the European Union's Capital Requirements Directive IV (CRD IV) have aimed to strengthen governance frameworks and promote best practices within the banking industry. These reforms mandate the establishment of dedicated risk committees, stress testing practices, clawback provisions in remuneration structures, and the implementation of effective compliance and auditing functions. Effective implementation of corporate governance reforms is crucial for enhancing financial stability, mitigating systemic risks, and protecting depositors' interests. By promoting responsible and ethical practices, strengthening oversight mechanisms, and aligning incentives with long-term sustainability, these reforms aim to restore public confidence in the banking industry and contribute to the overall resilience of the financial system. Keywords: Corporate Governance, Banking Regulations, Risk Management, Transparency, Financial Stability

Impact of Monetary Policy on Stock Market Volatility

Purpose: The general objective of the study was to analyze the impact of monetary policy on stock market volatility. Methodology: The study adopted a desktop research methodology. Desk research refers to secondary data or that which can be collected without fieldwork. Desk research is basically involved in collecting data from existing resources hence it is often considered a low cost technique as compared to field research, as the main cost is involved in executive’s time, telephone charges and directories. Thus, the study relied on already published studies, reports and statistics. This secondary data was easily accessed through the online journals and library. Findings: The findings reveal that there exists a contextual and methodological gap relating to the impact of monetary policy on stock market volatility. Preliminary empirical review revealed that monetary policy exerts significant influence on stock market volatility through various channels such as interest rate adjustments, quantitative easing, and forward guidance. It highlighted that the timing and clarity of policy announcements play a crucial role in shaping market reactions, with unexpected shifts often leading to heightened volatility. Global interconnectedness amplified these effects, underscoring the need for coordinated policy responses. Behavioral factors also contributed, as investor sentiment and market psychology could magnify volatility independently of economic fundamentals. Understanding these dynamics is crucial for effective policy design and market stability amidst evolving financial landscapes. Unique Contribution to Theory, Practice and Policy: Efficient Market Hypothesis (EMH, Rational Expectations Theory and Keynesian Economics may be used to anchor future studies on monetary policy on stock market volatility. Recommendations from the study included integrating behavioral finance models into economic frameworks to enhance predictive accuracy. It advocated for clearer and more consistent central bank communications to align market expectations with policy actions, reducing uncertainty-driven volatility. Collaborative efforts among central banks were emphasized to manage international spillovers and enhance global financial stability. Adaptive policy frameworks were proposed to respond flexibly to changing market conditions while promoting regulatory measures to safeguard against excessive risk-taking. These recommendations aimed to foster a stable financial environment supportive of sustainable economic growth and market confidence.

Influence of Executive Compensation on Firm Risk-Taking Behavior in Qatar

Purpose: The aim of the study was to assess the influence of executive compensation on firm risk-taking behavior in Qatar. Methodology: This study adopted a desk methodology. A desk study research design is commonly known as secondary data collection. This is basically collecting data from existing resources preferably because of its low cost advantage as compared to a field research. Our current study looked into already published studies and reports as the data was easily accessed through online journals and libraries. Findings: The study indicated that the structure and magnitude of executive compensation can significantly impact the risk profile of a firm. When executives are rewarded with substantial stock options and performance-based incentives, they are often motivated to pursue riskier strategies that have the potential for higher returns, aligning their interests with those of shareholders. However, this can also lead to excessive risk-taking, which may jeopardize the firm's stability if not managed properly. Conversely, fixed salaries and lower levels of variable compensation tend to promote more conservative decision-making, reducing the propensity for risk. The balance and design of executive compensation packages are thus crucial in ensuring that executives take calculated risks that contribute to sustainable firm growth rather than engaging in hazardous financial behaviors that could lead to adverse outcomes. Implications to Theory, Practice and Policy: Agency theory, tournament theory and stewardship theory may be used to anchor future studies on assessing the influence of executive compensation on firm risk-taking behavior in Qatar. Implement compensation structures that strategically align executive incentives with organizational risk strategies. Collaborate with regulatory bodies to enhance governance frameworks that govern executive compensation.

National culture and Islamic bank risk-taking in the Middle East and Asian countries

ABSTRACT This study investigates the influence of the national culture on risk-taking in Islamic banks. The sample comprises 60 Islamic banks in the Middle East, Southeast Asia, and South Asia from 2011 to 2019. Using the random effects generalized least squares model, we find that national culture influences risk-taking in Islamic banks, especially in the power distance dimension. Low power distance incentivizes greater risk. In low power distance countries, Islamic banks tend to adopt a more aggressive approach to their decisions because of the trust and authority of shareholders and depositors, resulting in excessive risk-taking. The findings have implications for regulators and Islamic bank managers to consider national cultural elements when developing bank risk management policies.

Securitization and risk appetite: empirical evidence from US banks

I investigate the impact of securitization on the risk-taking by bank holding companies (BHCs). For 2001 to 2017, I find a negative relationship between securitization and the risk appetite of BHCs. I find a negative relationship between securitization and the risk appetite of BHCs that is consistent with the recourse hypothesis of securitization. I also discover that the equilibrium in this relationship changes from the pre-crisis to the crisis period (crisis effect). This crisis effect hampers BHCs’ ability to engage in securitization that leads them to accumulate more risky assets on their books due to the deteriorated quality of their loan portfolios. This equilibrium then reverses after the crisis (post-crisis effect) due to policy makers’ response to the excessive risk-taking that manifested during the crisis. Moreover, I find that the securitization of residential mortgages not only boosts the recourse hypothesis but also triggers the crisis effect. My findings provide novel empirical insights into the different nexuses between the securitization and risk appetite of BHCs around the financial crisis.

Changing risk-taking: the effects of tasks and incentives on the variability of risk-taking

The capability to vary risk-taking is an important aspect of performance in organizations where behavioral adjustments are required to suit changing objectives. Incentive schemes are one way to influence risk-taking. Yet, evidence indicates incentives do not have their intended effects and may encourage excessive risk-taking. To examine this issue, we draw on compensation activation theory that proposes individual motives are activated by specific features of compensation schemes and expressed in behaviors. We extend compensation activation theory by focusing on (1) responses to a sequence of tasks designed to activate risk-taking and (2) the effects of incentive schemes on these relationships. We conducted a laboratory experiment with 173 participants who were allocated randomly to one of three bonus schemes. The linear scheme has a linear relationship between returns from risk-taking and rewards. The bonus cap scheme operates similarly up to a point where no further rewards are paid. The outcome-adjusted scheme, with a two-year hypothetical time frame, requires realized gains for the first year of investment and no losses in next year. Results support our hypotheses that these incentive schemes have differential effects on the strength and direction of relationships between risk-taking across a sequence of tasks. The linear scheme strengthens the relationships between risk-taking across sequential tasks. Conversely, the bonus cap scheme weakens the relationships between risk-taking across sequential tasks. The outcome-adjusted scheme creates variability by decreasing risk-taking when the connections between risk-taking and rewards are less salient and increasing risk-taking when connections between risk-taking and rewards are more salient. We contribute to the literature concerning compensation activation and incentives by deepening our understanding of the roles played by tasks and incentives in activation processes and by explaining the variability of risk-taking in terms of changes in connections between behavior and rewards.

Board structure and risk-taking behavior: evidence from the financial sector of Pakistan

PurposeThe board structure (BS) is pivotal in modern corporate governance (CG). This study aims to investigate BS variables (BSIZE, BIND and chief executive officer [CEO] duality) and their correlation with risk-taking behavior indicators, enriching the understanding of how CG shapes financial institutions’ (FIs) decision-making in Pakistan.Design/methodology/approachBy scrutinizing data from 67 financial entities listed on the Stock Exchange of Pakistan spanning from 2011 to 2022 through panel data regression techniques, the research emphasizes that BS holds a substantial influence over the risk tendencies exhibited by these firms.FindingsKey findings suggest that board size has a positive influence, aligned with previous CG research. Smaller boards perform better and avoid excessive risk-taking, contrasting some negative relationship claims. More independent directors are recommended to curtail risk and financial disruption. Holding both CEO and chair roles reduces risk exposure, resonating with reputational and employment risk theory. It is essential to recognize that BS’s impact on risk-taking is nuanced and context-dependent.Practical implicationsPolicymakers, scholars, practitioners and investors working in the market for financial companies might greatly benefit from the empirical findings of this study. Imposing mandates on FIs to uphold adequate capital reserves functions as a safeguard against unforeseen losses, thereby diminishing the probability of unwarranted risk-taking.Originality/valuePrior studies in this domain predominantly focus on nonfinancial sectors. In addition, existing research often explores the relationship between BS and firm risk-taking solely within the banking sector, overlooking other FIs. This study contributes by using a comprehensive data set encompassing all types of FIs, thus extending the existing literature.

ESG 경영과 기업 위험추구행위의 관계, 그리고 기업가치

[Purpose] This study investigates the association between ESG management and corporate risk-taking, and further examines how the level of corporate risk-taking affects the relationship between ESG management and firm value. Shareholders have an incentive to maximize profits through corporate risk-taking, but ESG management monitors and suppresses the excessive risk-taking by considering the benefits of not only shareholders but also various stakeholders around the firm and pursuing transparent governance and the promotion of social value. In addition, if ESG investment(insurance-like assets) increases, the amount invested in risky investments may relatively decrease, thereby reducing overall corporate risk-taking. However, on the other hand, since ESG activities generally involve investing in sectors that do not directly generate profits, managers may actively invest in risky businesses that can secure more profits to make up for these expenditures. Because such conflicting predictions are possible, the association between ESG management and corporate risk-taking is an issue which requires empirical analysis.
 [Methodology] A regression analysis was performed for domestic listed firms from 2012 to 2018 using ESG evaluation ratings provided by KCGS and corporate risk-taking variables measured by standard deviation of future profit rate. Also, this study investigates the effect of the interaction term between ESG and risk-taking level to examine the impact of corporate risk-taking on the relationship between ESG management and firm value.
 [Findings] This study finds that the higher ESG evaluation score, the lower corporate risk-taking, and this negative relationship was significant in the governance element among the three elements of environment, social, and governance. Additionally, a significantly positive relationship between ESG management and firm value exists only when the level of corporate risk-taking is low, and there is no such relationship when the level of corporate risk-taking is high.
 [Implications] This study contributes to the accounting literature by showing that ESG management affects corporate risk-taking related to investment activities and that ESG management has a positive impact on firm value only when excessive risk-taking is restrained.

Bank connectedness and excessive risk-taking: Some cross-country evidence

We investigate whether the connectedness of banks shapes their incentive to take on excessive risk, using panel data from more than 400 public banks in 19 economies during the period of 2000–2018. We find supportive evidence that banks’ excessive risk-taking is significantly associated with their connectedness and the impact of banks’ directional connectedness varies. A higher outward connectedness significantly fuels banks’ incentive to take excessive risk, while a higher inward connectedness has a countervailing effect

Expansionary Monetary Policy and Bank Loan Loss Provisioning

We explore how expansionary monetary policy (EMP) influences bank loan loss provisioning. We find that banks’ discretionary loan loss provisions (DLLPs) increase during periods of EMP. This effect is stronger for banks with greater risk-taking, a larger proportion of influential stakeholders, lower ex-ante transparency of loan loss provisions, and more stringent bank regulation, which is consistent with external stakeholders requiring more conservative and timelier loan loss provisioning. We also find that both the timeliness and the validity of banks’ loan loss provisions (LLPs) increase during EMP periods. Our results are robust to the use of instrumental variable estimation and exogenous variations in monetary policy. Lastly, we show that conservative (i.e., higher DLLPs) and timely loan loss provisioning discipline banks from excessive risk-taking during periods of EMP.

The role of inside debt in banks’ M&A choices: wealth expropriation or conflict resolution?

PurposeThis study investigates the impact of bank CEOs’ inside debt on shareholder benefits in the context of bank mergers and acquisitions (M&A) before the 2008–2009 financial crisis.Design/methodology/approachEmploying an event-study methodology, this analysis delves into market reactions to bank M&A announcements during 2006–2007, encompassing 105 M&As by 79 public commercial banks. This era witnessed heightened risk-taking behavior on the verge of the financial crisis. We explore the relation between relative inside debt and market abnormal returns at M&A announcements and the association between relative inside debt and cash payment preferences in M&As.FindingsEvidence suggests that M&A announcements from banks where acquiring CEOs hold a substantial inside debt experience favorable stock market reaction, particularly for smaller banks. Additionally, banks with elevated CEO inside debt tend to favor cash as a payment mode for M&As.Research limitations/implicationsOne limitation of this study is the short period of data availability. The data used in this study covers only 2006 and 2007, the periods marked by notable risk-taking activities on the verge of the financial crisis. Although this period is perfectly suitable for our investigation, given the prevalence of conflicts between equity and debt holders, it is essential to acknowledge that our findings may not capture changes or trends over time. Nevertheless, the results offer valuable insights into the factors that influence the behavior of the studied population. Future research could employ a longitudinal design to address this limitation and gain a more comprehensive understanding of the dynamics over extended periods.Practical implicationsOur study has significant implications for businesses and policymakers as it provides insights into the factors contributing to financial crises and how compensation mechanisms can be used to moderate bank risk-taking. We propose that CEO inside debt compensation presents a plausible mechanism that boards of directors can incorporate into bank executive compensation contracts. By doing so, they can promote value-enhancing investments and moderate excessive risk-taking, thereby safeguarding the financial stability of individual banks and overall financial system.Originality/valueOur study sheds light on the beneficial role of bank CEO inside debt for shareholders, contributing empirical backing to the conflict resolution viewpoint in the discourse on wealth appropriation. From a regulatory stance, our findings advocate for the inclusion of bank CEO inside debt in executive remuneration agreements. Such a strategy can empower boards of directors to mitigate undue risk and enhance shareholder value in M&As, safeguarding both individual bank and broader financial system stability.

Banking supervision with loopholes

This paper develops a model of financial intermediation focusing on the interaction between banks and a regulator. In the model, the regulator chooses its supervision capacity to monitor banks and prevent excessive risk-taking. Meanwhile, banks can engage in loophole innovation to circumvent supervision, diminishing the value of the regulator’s accumulated expertise. In equilibrium, as the regulator’s supervision capacity increases, loophole innovation is more likely to succeed. In the dynamic framework, our model generates pro-cyclical bank leverage and asymmetric credit cycles. After a longer boom, a crisis is more likely to occur, and the consequences are more severe. We analyze the welfare implications of maximum leverage regulation and other regulatory tools in the loophole innovation environment.

Rational overoptimism and limited liability

Is excessive risk-taking in credit cycles driven by incentives or biased beliefs? I propose a framework suggesting that the two are actually related and, specifically, that procyclical overoptimism can arise rationally from risk-taking incentives. I show that when firms and banks have a limited liability payoff structure, they have lower incentives to pay attention to the aggregate conditions that generate risk. This leads to systematic underestimation of the accumulation of risk during economic booms and overoptimistic beliefs. As a result, agents lend and borrow excessively, further increasing downside risk. Credit cycles driven by this new “uninformed” risk-taking are consistent with existing evidence such as high credit and low-risk premia predicting a higher probability of crises and negative returns for banks. My model suggests that regulating incentives can decrease overoptimistic beliefs and thus mitigate boom-and-bust cycles.

Sukūk development and income inequality

This paper investigates the link between sukūk development and income inequality by scrutinizing twenty-two countries’ data from 1995 to 2019. We employ the two-stage Fractional Regression Model to illustrate that sukūk issuance is associated with increased income disparity. This result is attributed to the sukūk design ignoring credit market frictions. This rationalizes the sukūk-inequality nexus in light of the ethical objectives of Islamic law. We argue that reinforcing property rights by mitigating the ill effects of excessive risk-taking (i.e., gharar) and endemic agency costs of debt (i.e., ribā) in our ethical framework can improve sukūk’s role in socio-economic development.

The neural substrates of how model-based learning affects risk taking: Functional coupling between right cerebellum and left caudate

Higher executive control capacity allows people to appropriately evaluate risk and avoid both excessive risk aversion and excessive risk-taking. The neural mechanisms underlying this relationship between executive function and risk taking are still unknown. We used voxel-based morphometry (VBM) analysis combined with resting-state functional connectivity (rs-FC) to evaluate how one component of executive function, model-based learning, relates to risk taking. We measured individuals’ use of the model-based learning system with the two-step task, and risk taking with the Balloon Analogue Risk Task. Behavioral results indicated that risk taking was positively correlated with the model-based weighting parameter ω. The VBM results showed a positive association between model-based learning and gray matter volume in the right cerebellum (RCere) and left inferior parietal lobule (LIPL). Functional connectivity results suggested that the coupling between RCere and the left caudate (LCAU) was correlated with both model-based learning and risk taking. Mediation analysis indicated that RCere-LCAU functional connectivity completely mediated the effect of model-based learning on risk taking. These results indicate that learners who favor model-based strategies also engage in more appropriate risky behaviors through interactions between reward-based learning, error-based learning and executive control subserved by a caudate, cerebellar and parietal network.

How macroprudential regulation and board effectiveness interact to shape bank risk-taking behavior

This study aims to investigate how macroprudential policies and corporate governance interact to curb bank risk-taking behavior for a sample of 915 publicly listed commercial banks in 53 countries over the 2011–2020 period. Excessive risk-taking by global financial institutions was singled out during the global financial crisis of 2007–2009. We first use a fixed-effects OLS panel model. Then, to address endogeneity concerns, we apply a two-step system GMM estimation. Our results show that the impact of board attributes on risk-taking depends critically on MPP’s policies. We find that MPPs can enhance the supervisory power of a board characterized by high independence, and a CEO who performs a dual function. However, a large board size appears to increase bank risk when multiple macroprudential policies are in place, which can result in managerial policies that may increase bank risk-taking. The supervisory role of women on the board is only effective in the presence of tight macroprudential policies. Bank regulators should consider the interaction between corporate governance and macroprudential policies when designing more effective bank regulations.

Capital buffers, business models and the probability of bank distress: a dynamic panel investigation

PurposeThis paper aims to improve the debate linking the business models of banks to their riskiness by checking if diversification exerts different impacts on the probability of bank distress depending on the level of capital buffers.Design/methodology/approachThe paper focuses on a sample of listed bank holding companies observed between 2007:Q3 and 2022:Q4. The authors use three subindexes of bank diversification. The authors estimate a dynamic model specification using a system generalized method of moments with robust standard errors and consistent estimators under heteroskedasticity and autocorrelation within a panel. Sensitivity and robustness checks are performed.FindingsAsset and income diversification increase the probability of distress in low-capitalized banks during normal periods (excluding periods of crises and high uncertainty). Concerning crisis periods, a marginal increase in asset diversification during the global financial crisis (GFC) and the COVID-19 pandemic crisis induces a more important increase in the probability of failure of well-capitalized banks relative to low-capitalized ones. Contrary to the results obtained for the GFC period, well-capitalized banks were found to pursue more careful funding diversification in reaction to the sudden increase of uncertainty during the Russia–Ukraine war.Research limitations/implicationsPrudential supervision should concentrate on well-capitalized banks to encompass unexpected excessive risk-taking during crisis periods. Regulatory requirements should constrain fragile banks to avoid pursuing assets and income diversification strategies that increase earnings volatility.Originality/valueThe main originality of this paper is to consider the interaction between three different dimensions of bank diversification and capital regulation during stable and unstable periods using the marginal effect analysis. Moreover, this paper uses, initially, the GFC as the reference crisis period to study the impact of capital buffers and diversification interactions on the probability of bank distress. Then, the authors extend the observation period until 2022:Q4 to include two additional major events, namely, the COVID-19 pandemic and the Russia-Ukraine war.

Microfinance's digital transformation for sustainable inclusion

PurposeThe purpose of this paper is to evaluate the performance of Microfinance Institutions (MFIs) offering FinTech services. This study contributes to the existing literature on microfinance digitalization, financial inclusion and sustainable development. The study also takes into consideration a behavioral perspective through the efficiency evaluation process of MFIs offering FinTech services.Design/methodology/approachThe following study employs the Stochastic Frontier Analysis approach to estimate the operational and social efficiency scores of the 387 MFIs over the period 2005–2019. Then, it tries to consider factors influencing MFIs' efficiency and assess their effects. Hence, two separate models for operation and social efficiency introducing a set of factors, including FinTech proxies and overconfidence proxies, are tested. The first model for operational efficiency uses a random-effects estimator while the second one for social efficiency uses a fixed-effects estimator.FindingsThe results show that innovative MFIs have weaker averages of operational efficiency than non-innovative ones but higher averages of social efficiency. This was justified by the fact that innovative MFIs are more socially oriented. Further, findings of this study depict that the proxies of FinTech affect negatively the level of operational efficiency of MFIs. They also depict a negative relationship between FinTech proxies and the level of social efficiency. These results hold through robustness tests.Originality/valueThe highlight of this study is that it takes heed of the indirect effect of technological innovation on the efficiency of MFIs. It has been proved that it moderates the impact of managerial overconfidence (manifested by excessive risk-taking, viz., high levels of PAR30, LGR and NIM) on the level of both operational and social efficiencies.

Behavioral Agency Model and Corporate Social Irresponsibility: Uncovering the Implication of Fairness in CEO Compensation

Behavioral agency model (BAM) posits that executive risk preferences are influenced by losses to their current option wealth relative to gains from their prospective option wealth. Accordingly, current option wealth attenuates risk-taking while prospective option wealth amplifies risk-taking. In the context of corporate irresponsible behaviors, this study attempts to advance the BAM by theorizing how the presence of conditions that give rise to distributive and procedural injustice in CEO compensation can further amplify the positive effects of CEO prospective option wealth on risk-taking, thereby destroying stakeholder value. Our findings, based on a longitudinal cross-sectional sample of 8,669 firm-year observations for the period 2001 to 2018, support our theorization that CEO perceptions of unfairness in compensation amplify excessive risk-taking, thereby increasing the likelihood of corporate social irresponsibility. Our study has important implications for advancing the BAM and for the study and design of executive compensation.