In this paper we present a model of executive compensation to analyze the link between incentive compensation and risk taking. Our model takes into account the loss in the value of an executive's expected wealth from employment if the firm becomes insolvent during a bad state of the economy. We...

We present a model where bank assets are a portfolio of risky debt claims and analyze stockholders' risk-taking behavior while considering the strategic interaction between debtors and creditors. We find that: (1) as the leverage of a bank increases, risk shifting by borrowers increases, even if...

We present a theory for the puzzling issue regarding why certain firms in financial distress, prefer a costlier formal bankruptcy procedure over direct renegotiations. We show that claimholders' heterogeneous beliefs about the results of a formal plan and about judicial discretion may lead to...

We present an equilibrium model of financial institutions to examine the optimal regulation of risk taking. Shareholders set compensation incentivizing management to increase risk to excessive levels. Regulators use caps on asset risk and compensation to achieve the socially optimal risk level....