Staff Reports

Agency Problems and Risk Taking At Banks

September 1997Number 29
JEL classification: G2, G3

Authors: Rebecca S. Demsetz, Marc R. Saidenberg,
and Philip E. Strahan

The moral hazard problem associated with deposit insurance generates the potential for excessive risk taking on the part of bank owners. The banking literature identifies franchise value—a firm's profit-generating potential—as one force mitigating that risk taking. We argue that in the presence of owner/manager agency problems, managerial risk aversion may also offset the excessive risk taking that stems from moral hazard. Empirical models of bank risk tend to focus either on the disciplinary role of franchise value or on owner/manager agency problems. We estimate a unified model and find that both franchise value and ownership structure affect risk at banks. More important, we identify an interesting interaction effect: The relationship between ownership structure and risk is significant only at low franchise value banks—those where moral hazard problems are most severe and where conflicts between owner and manager risk preferences are therefore strongest. Risk is lower at banks with no insider holdings, but among other banks, there is no relationship between the level of insider holdings and risk. This suggests that the owner/manager agency problem affects the choice of risk for only a small number of banks—those with low franchise value and no insider holdings. Most of these banks increase their insider holdings within a year, and these changes in ownership structure are associated with increased risk. This suggests that owner/manager agency problems are quickly addressed.

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