The Conflict between Fixed Claimants and Shareholders
A conflict between the interests of debt holders and the interests of shareholders exists in every firm. Among any particular set of asset allocation decisions, any investment strategy that increases risk will transfer wealth from the fixed claimants to the residual claimants.
This problem is raised to a new dimension in the banking context because of the high debt equity ratio and the existence of deposit insurance. In the publicly held corporation, the problem of excessive risk-taking is mitigated by two factors.
First, various devices serve to protect fixed claimants against excessive risk-taking .Corporate lenders typically insist on protection against actions by corporate managers that threaten their fixed claims.
Second, risk-taking is reduced to some extent because managers are not perfect agents of risk-preferring shareholders. Managers are fixed claimants to that portion of their compensation designated as salary.
In addition, managerial incentives for risk-taking are reduced, since managers have invested their non diversifiable human capital in their jobs. This capital would depreciate significantly in value if their firms were to fail.
The second risk-reducing factor—the fact that managers tend to be more risk-averse than shareholders—is present for commercial banks as well as other corporations.
What makes banks fundamentally different from other types of firms, however, is the lack of significant discipline of other fixed claimants.
FDIC insurance removes any incentive that insured depositors have to control excessive risk-taking because their funds are protected regardless of the outcomes of the investment strategies that the banks select..
Thus, depositors of insured financial institutions cannot be expected to exert the same degree of restraint on excessive risk-taking as other fixed claimants, and this enhances the degree of influence exerted by shareholders, whose preference is to assume high levels of risk.
The adverse incentive for risk-taking caused by federal insurance is one reason to have stricter accountability requirements for directors of banks.
A conflict between the interests of debt holders and the interests of shareholders exists in every firm. Among any particular set of asset allocation decisions, any investment strategy that increases risk will transfer wealth from the fixed claimants to the residual claimants.
This problem is raised to a new dimension in the banking context because of the high debt equity ratio and the existence of deposit insurance. In the publicly held corporation, the problem of excessive risk-taking is mitigated by two factors.
First, various devices serve to protect fixed claimants against excessive risk-taking .Corporate lenders typically insist on protection against actions by corporate managers that threaten their fixed claims.
Second, risk-taking is reduced to some extent because managers are not perfect agents of risk-preferring shareholders. Managers are fixed claimants to that portion of their compensation designated as salary.
In addition, managerial incentives for risk-taking are reduced, since managers have invested their non diversifiable human capital in their jobs. This capital would depreciate significantly in value if their firms were to fail.
The second risk-reducing factor—the fact that managers tend to be more risk-averse than shareholders—is present for commercial banks as well as other corporations.
What makes banks fundamentally different from other types of firms, however, is the lack of significant discipline of other fixed claimants.
FDIC insurance removes any incentive that insured depositors have to control excessive risk-taking because their funds are protected regardless of the outcomes of the investment strategies that the banks select..
Thus, depositors of insured financial institutions cannot be expected to exert the same degree of restraint on excessive risk-taking as other fixed claimants, and this enhances the degree of influence exerted by shareholders, whose preference is to assume high levels of risk.
The adverse incentive for risk-taking caused by federal insurance is one reason to have stricter accountability requirements for directors of banks.