Bank Risk-Taking, Managerial Overconfidence, and Punishment Threats

Abstract

It has been recognised that a major contributory factor to the current financial crisis has been the excessive risk-taking behaviour of the banking sector. The UK Banking Commission Report proposes, as a remedy, that bankers who take excessive risks that lead their banks into bail-out situations should be threatened with prison sentences. In this paper, we develop a game-theoretic analysis that considers the combined effect of punishment threats and managerial overconfidence on banks’ risk-taking activities. Our model demonstrates that punishment threats may not be as fully effective as policy-makers believe. We consider three managerial types: a) fully rational managers, who may be deterred by the punishment threat from taking ‘proper’ and appropriate risks (such as lending to innovative entrepreneurial start-ups and SMEs), b) highly overconfident managers who do not fully appreciate or understand the risks that they are taking, and hence ignore the punishment threat, and c) a group of medium overconfidence managers for whom the punishment threat is effective. Overall, our model suggests that an optimal level of punishment may exist that deters excessive, value-reducing risk-taking without deterring proper and appropriate risk-taking by banks.