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Edited by James R. Barth, Chen Lin and Clas Wihlborg
Chapter 11: Restricting Risk-taking by Financial Intermediaries through Executive Compensation
Tom Berglund The financial crisis that started in 2007 and peaked in 2008–2009 clearly revealed that there are externalities in financial intermediation that markets as such are unable to handle. The question that governments and regulatory bodies around the world are trying to answer presently is how these externalities should be addressed. Finding appropriate solutions is not made easier by the fact that there is a strong popular sentiment against bankers in general, who are seen as the culprits for the fall in living standards as a consequence of the crisis in most countries around the world. In the aftermath of the Great Depression in the 1930s demand for a strict banking regulation was triggered by deposit insurance that was introduced to stave off bank runs. In that crisis the existence of even sound banks was threatened by withdrawals from panic-stricken depositors. However, deposit insurance, that removed this threat, created a moral hazard problem: when banks are allowed to fund their activities with cheap deposits that are guaranteed by the government, excessive risk-taking by an individual bank will not be appropriately penalized by the market. While this externality has been well known, and constitutes the basis for relatively strict banking supervision around the world, the new insight that the recent crisis has forcefully highlighted is that these externalities are not limited to deposit-taking banks. Big and highly interconnected financial institutions will be subject to externalities too, even if none of their funding comes in the form of deposits. The...
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