How to Get Banks to Take Less Risk and Disclose Bad News, Journal of Financial Intermediation
There is wide agreement that before the recent financial crisis, financial institutions took excessive risk in their investment strategies. At the same time, regulators complained that banks did not reveal the extent of their difficulties in a timely fashion thus reducing the effectiveness of government intervention to prevent or mitigate the deleterious effects of the financial crisis. The purpose of this paper is to investigate how regulators can best use certain tools at their disposal to motivate banks to take less risk and to provide adverse information to regulators early. We argue that two tools, namely restricting bank payouts to equity holders when banks report they are in trouble and constraining banks’ future investment strategy when they are in trouble can achieve both goals. We show that, in some cases, optimal use of these tools involves allowing equity payouts, even though these payments are financed by taxpayers. We also show that the more socially costly is constraining the bank’s portfolio selection or the more complex are the bank’s assets, the more likely it is that allowing larger payouts and fewer constraints is optimal.
Artur Raviv, Milton Harris
Raviv, Artur, and Milton Harris. 2014. How to Get Banks to Take Less Risk and Disclose Bad News. Journal of Financial Intermediation. 23: 437–470.