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A Regulator's Exercise Of Career Option To Quit And Join A Regulated Firm's Management With Applications To Financial Institutions

The following is a summary of the results presented in the hyperlinked paper entitled: A Regulator's Exercise of Career Option To Quit and Join A Regulated Firm's Management with Applications to Financial Institutions

For firms in a regulated industry, the public sector often define their operating parameters. Thus firms' profit opportunities are constrained. Moreover, regulatory agencies provide oversight and enforce those constraints which are delegated to regulators who interact with firm management. Thus, there are risks in the process. If regulators fail to enforce the constraints as expected, there are moral hazard costs that the public may bear. By contrast, if regulators exceed the intended constraints, then firm profitability is affected and that may lead to firm inefficiency. In that context, for the duration of their careers, regulators hold a range of valuable options which, depending on how they are exercised, may benefit the regulated firms and their shareholders at the expense of the public or vice versa. Hence, the regulator problem is embedded with moral hazard risk that the public may wish to curtail.

Consider the American banking sector. Within established parameters and guidelines, commercial bank franchises are intended to meet public credit needs while providing returns to their shareholders. Monitoring and examining the bank "franchises" in the U.S. give rise to a range of regulators - depending on whether the institutions are federally or state chartered. Further, regulations arise with respect to protections for depositors. Other related considerations of risk and return drive further monitoring and restrictions in banking. For example, financing activities and asset acquisitions are also constrained (e.g. no common stock investments); prices may be regulated or not (e.g. Regulation Q); capital adequacy may be proscribed both with respect to quantity and to mix of debt and equity; asset growth may be facilitated or not (e.g. appropriate collateral, and margin requirements on stock purchases etc). It is normal in banking for regulations to produce push - pull tensions, with management desiring greater degrees of freedom than may be allowed under the status quo.

Such tensions provide opportunities wherein regulators might exercise their discretion to support the management "push" or the public "pull" in their reports to bank management, to policy makers, and the public. For example, it is a regulator's responsibility to evaluate management and bank performance on such things as earnings and financial leverage and to assign comparative institutional rankings (e.g. CAMELS scores). In that process, the regulator builds a career whose market value changes with the exercise of their discretion. This process is known, and as a result, costly departure barriers are established to restrain regulators and minimize conflicts of interest. However, it is likely that market for [ex]regulators discount such departure costs.

In our model, a regulator designs an abstract mechanism that embeds regulatory signals in the firm's capital structure to induce the firm to engage in some desired action. For instance, she may engage in regulatory forbearance for highly levered firms, or [s]he may favor tax cuts on capital gains or tax deduction of interest expense or deregulation of an industry because a particular firm that [s]he intends to join after leaving her regulatory position is an industry leader. So [s]he designs a mechanism, i.e. a vicarious contract, for that purpose. However, agency conflicts arise from information asymmetry when the regulator has information about career options [s]he plans to exercise in the future, and stake holders in the firm or members of the public do not.