Revolutionizing Bank Regulation: New Instruments to Control Risk
Bank regulations focusing on capital requirements aim to control risk, but they may not be the most effective method. By using financial instruments like convertible debt and warrants, banks can better manage risk and potentially reduce traditional capital requirements. The analysis in the article suggests that agency theory plays a crucial role in understanding how limited liability and deposit insurance can incentivize banks to take excessive risks. By fine-tuning the payoff structure with specific securities, banks can optimize their risk management strategies.