infonet-economy

This paper shows how to design incentive-based capital requirements that would prevent the bank from manufacturing tail risk. In the model, the senior bank manager may have incentives to engage in tail risk. Bank shareholders can prevent the manager from taking on tail risk via the optimal incentive compensation contract. To induce shareholders to implement this contract, capital requirements should internalize its costs. Moreover, bank shareholders must be given the incentives to comply with minimum capital requirements by raising new equity and expanding bank assets. Making bank shareholders bear the costs of compliance with capital regulation turns out to be crucial for motivating them to care about risk-management quality in their bank.