Emory Law Journal

Regulating Risk and Governance in Banks: A Contractarian Perspective
Simone M. Sepe J.S.D.–Ph.D. Associate Professor of Law and Finance, The University of Arizona James E. Rogers College of Law. E-mail: simone.sepe@law.arizona.edu. I would like to thank the following people: Alan Schwartz, Henry Hansmann, and Jacques Crémer—for their continuous support and guidance; Randall Thomas, Margaret Blair, Paul Edelman—for thoughtful comments; Bob Mundheim—for his interest in my research; Chuck Whitehead—for a fruitful initial conversation on the topic of this Article; Barbara Atwood, Kathie Barnes, Jean Braucher, Ellie Bublick, Robert Glennon, Barak Orbach, Dave Marcus, Toni Massaro, Marc Miller, Chris Robertson, Carol Rose, Billy Sjostrom, and Ted Schneyer—for being great colleagues and taking time to discuss this Article; and workshop participants at the Vanderbilt Law School Law & Business Program and the University of Iowa College of Law Faculty Speakers Series—for useful remarks. I also wish to thank Jared Buszin, Amanda M. Baker, and the staff of the Emory Law Journal—for their professionalism and excellent editorial comments, and my research assistant, John Champagne—for his help in preparing this Article. Most of all, I am indebted to my wife Saura Masconale—for her fundamental contribution to the development and implementation of this project.

In the lead up to the 2007–2008 financial crisis, U.S. banks engaged in systemic, excessive risk taking that drove the economy to the verge of collapse. This Article makes three contributions to understanding how this pandemic of excessive bank risk taking was possible and which policy reforms are desirable to promote more prudent banking conduct.

First, this Article counters the common narrative that blames the crisis on managerial moral hazard. Instead, it focuses on bank shareholders and debtholders, arguing that their distorted incentives drove banks to take excessive risks. Corporate finance theory teaches that debtholders charge higher interest rates in response to the shareholders’ preferences for high-risk, high-return projects. In highly leveraged firms, this incentivizes shareholders, eager to minimize the cost of debt, to seek safe governance arrangements that can commit their firms to sound risk choices. But in the banking sector, deposit insurance and bailouts undermine this balance, causing debtholders to become less sensitive to risk taking. As a result, bank shareholders, shielded by limited liability and unconstrained by debtholder monitoring, rationally support governance arrangements that incentivize risk taking.

This Article’s second contribution is normative: it develops a contractarian approach to bank regulation in order to overcome the distortions that affect bank governance. Under this approach, regulators should assume the hypothetical position of bank debtholders in a world without safety nets, and they should discipline banks as debtholders would in such a world. Where debtholders would offer lower interest rates in exchange for safer governance, regulators would offer lower capital requirements and lower deposit insurance premiums while demanding the same governance concessions. By promoting more socially responsible risk taking, this policy reform would add to bank safety and overall economic stability.

Finally, this Article provides a conceptual foundation for designing and implementing safe governance arrangements in banks.

Introduction

The events leading up to the banking crisis of 2007–2008 have been extensively publicized. 1Most of the books that have appeared in the aftermath of the crisis to analyze its causes include a detailed account of these events. See, e.g., Darrel Duffie, How Big Banks Fail and What To Do About It (2011); Simon Johnson & James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (2011); Raghuram G. Rajan, Fault Lines: How Hidden Fractures Still Threaten the World Economy (2010); David Skeel, The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences (2011); Joseph E. Stiglitz, Freefall: America, Free Markets, and the Sinking of the World Economy (2010). Most U.S. banks made huge investments in the highly remunerative subprime market, while disregarding the enormous risks associated with these investments. When those risks finally materialized, they almost drove the U.S. banking system to collapse. 2By one estimate, the amount of public money spent to counter the collapse of the banking system approached 80% of U.S. GDP, i.e., about $12 trillion. See Stiglitz, supra note 1, at 110 (citing Mark Pittman & Bob Ivry, Fed’s Strategy Reduces U.S. Bailout to $11.6 Trillion, Bloomberg (Sept. 25, 2009, 4:39 PM), http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a3mpIdYuoB0M). More recent sources, however, have suggested that $13 trillion was the maximum level of taxpayer funds that were potentially at risk, and not an actual figure of the losses imposed by the crisis. See Jonathan R. Macey & James P. Holdcroft, Jr., Failure Is an Option: An Ersatz-Antitrust Approach to Financial Regulation, 120 Yale L.J. 1368, 1414 n.134 (2011). What is still puzzling, however, is how this was possible. Which failure can explain systematic, excessive risk taking by all of the U.S. banks?

One popular answer points to the failure of bank governance. On this view, rapacious bank CEOs usurped the corporate governance mechanisms that should have protected bank investors from excessive risk taking. 3 See sources quoted infra at note 93. This usurpation produced a system of skewed incentive schemes, complacent risk managers, and captured boards that allowed a pervasive culture of risk taking to flourish. This narrative, however, reflects an inadequate understanding of corporate governance theory and practice. It does not account for the causal relationship between external and internal governance. External governance is defined here as the pressure of oversight demands and backroom influence exercised by shareholders and debtholders. 4Shareholder and debtholder governance can be grouped together as external disciplinary forces coming from capital markets. In this respect, three caveats are in order. First, capital market discipline has traditionally been limited to the market for corporate control—the trading of equity interests including both economic and control rights over the corporation. See, e.g., Henry G. Manne, Mergers and the Market for Corporate Control, 73 J. Pol. Econ. 110, 112 (1965). In recent years, however, an extensive scholarship has developed on the active control exercised by creditors on their borrowers both through market and contractual mechanisms. See, e.g., George G. Triantis & Ronald J. Daniels, The Role of Debt in Interactive Corporate Governance, 83 Calif. L. Rev. 1073, 1077 (1995) (providing a seminal contribution on the interaction between debtholder and shareholder governance); Douglas G. Baird & Robert K. Rasmussen, Essay, Private Debt and the Missing Lever of Corporate Governance, 154 U. Pa. L. Rev. 1209, 1217 (2006) (arguing that an aggressive use of covenants can “obliterate the difference between debt and equity”); Frederick Tung, Leverage in the Board Room: The Unsung Influence of Private Lenders in Corporate Governance, 57 UCLA L. Rev. 115, 115 (2009) (stating that the extent of private lender influence rivals that of conventional governance mechanisms”). Second, it is important to note that classifying shareholder actions as external or internal to the corporate decision-making process is not always straightforward. Indeed, because of the special status enjoyed by shareholders as residual claimants, corporate law provides them with several institutional means to directly influence corporate decision making. See infra note 121 and accompanying text. However, in large corporations with dispersed shareholders, the exercise of these institutional means is mostly mediated by management, to whom shareholders delegate operational and decisional authority over corporate affairs. To this extent, shareholder governance is external to the corporate organization. See William R. Baber & Lihong Liang, Associations Between Internal and External Corporate Governance Characteristics and the Consequences of Regulating Governance Practices 2 (June 2008) (unpublished manuscript), available at http://ssrn.com/abstract=1146922 (“External governance defines the role of shareholder oversight . . . . In contrast, internal governance systems concern the interaction between or among firm insiders, specifically, management, directors, and employees.”). Instead, in corporations with controlling shareholders, shareholder governance is better described as internal because blockholders directly participate in the corporate decision-making process. See K.J. Martijn Cremers & Vinay B. Nair, Governance Mechanisms and Equity Prices, 60 J. Fin. 2859, 2859–60 (2005). Finally, in addition to capital markets, managerial labor markets and product markets also serve as sources of external discipline. See Triantis & Daniels, supra at 1075–76. While the analysis of managerial labor market discipline is outside the scope of this Article, it is important to observe that, in the particular case of banks, disciplinary forces coming from product markets and capital markets are largely overlapping. This is because the largest component of banks’ creditors—bank depositors—also are the most important consumers of the special good that banks produce: i.e., liquidity. These interactions directly inform internal governance, which comprises the organizational rules and bodies that discipline the corporate decision-making process—features including the board of directors, compensation schemes, and internal control procedures. 5Internal control procedures generally include auditing and accounting functions. But in the case of banks, risk management—the process through which a bank identifies, controls, and makes informed decisions about the risk affecting its operations—provides the most important internal control function. See Christine M. Cumming & Beverly J. Hirtle, The Challenges of Risk Management in Diversified Financial Companies, Econ. Pol’y Rev., Mar. 2001, at 1, 2 (expounding on the importance of risk management in modern financial corporations, e.g., banks). Understanding this causal relationship has more than mere theoretical implications: the interplay between external and internal governance exposes which regulatory approaches are cosmetic and which approaches can meaningfully constrain risk taking and preserve banking stability.

Adopting the conceptual framework above, this Article makes two important contributions: first, providing a causal analysis of the financial crisis, and second, developing a normative case for the future regulation debate. 6This Article uses the term bank differently within the positive and normative analyses that it develops. In the positive analysis of the dynamics that led to the crisis, the term bank is used to identify collectively commercial banks, stand-alone investment banks, and universal banks. In the normative analysis, the term bank identifies bank holding companies. See Bank Holding Company Act of 1956, 12 U.S.C. § 1841(a)(1) (2006) (defining a “bank holding company” as “any company which has control over any bank or over any company that is or becomes a bank holding company”). The transformation of Goldman Sachs and Morgan Stanley—the sole large investment banks that survived the crisis—into bank holding companies justifies this choice. Indeed, this change virtually put an end to the era of the independent investment bank, giving these firms access to deposit funding in return for being subject to stricter regulation. See Press Release, Bd. of Governors of the Fed. Reserve Sys., Order Approving Formation of Bank Holding Companies (Sept. 21, 2008), available at http://www.federalreserve.gov/newsevents/press/orders/20080922a.htm. The analytical component reframes the crisis as a moral hazard problem involving bank shareholders and debtholders, rather than bank managers. If there were no safety nets—deposit insurance and bailouts—the interaction between shareholder and debtholder governance would help to mitigate the problem of excessive risk taking. Economically, this problem arises from the shareholders’ preferences for high-risk, high-return projects. Indeed, under the limited liability of the corporate form, shareholders expect to reap the full upside from these projects, while debtholders bear most of the downside risk. 7The standard economic reference on the debt–equity conflict over a firm’s risk choices is Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305, 334–37 (1976). Anticipating these circumstances, debtholders demand higher interest rates, which reduce expected equity returns. 8The maximization of shareholders’ returns depends on both the managerial selection of profitable investment projects (i.e., the exercise of managerial effort) and the minimization of a firm’s costs, including the cost of debt. See Teresa A. John & Kose John, Top-Management Compensation and Capital Structure, 48 J. Fin. 949, 951 (1993) (“As residual claimholders, the shareholders gain from the reduced agency costs of debt.”). In response, shareholders have incentives to appease debtholders by committing their firms to sound risk policies 9 Cf. Kose John et al., A Theory of Bank Regulation and Management Compensation, 13 Rev. Fin. Stud. 95, 96 (2000) (suggesting that when debt is properly priced, the shareholders’ ex ante commitment to contractual solutions that can induce managers to implement value-maximizing investment policies is in the shareholders’ best interest). —for example through the managerial negotiation of contractual covenants that give debtholders authority to influence corporate decision making. 10 See infra text accompanying notes 139–40 (describing the various forms of debt covenants that are most commonly used as a firm’s commitment to sound risk choices). This Article suggests that in banks, absent safety nets, this implicit shareholder–debtholder negotiation over a firm’s risk choices would lead shareholders to seek internal governance arrangements that can distinguish their firms as safe investments. But with the introduction of safety nets, debtholders become less sensitive to risk taking. This leads to a theory of rational passivity of bank shareholders—unconstrained by debt discipline, bank shareholders have no incentives to police governance arrangements that induce risk taking. 11 Cf. Richard Squire, Shareholder Opportunism in a World of Risky Debt, 123 Harv. L. Rev. 1151, 1152–53 (2010) (suggesting that bank managers’ engagement in the particular opportunism hazard presented by contingent debt was in the interest of bank shareholders and, therefore, perfectly rational from the shareholders’ perspective). Instead, they find themselves benefitting from such arrangements.

To counter these distorted incentives, this Article suggests that bank regulators should adopt a contractarian approach, assuming the hypothetical position of uninsured bank debtholders. In this position, they would bargain for the same governance concessions from shareholders that debtholders would otherwise demand. 12The contractarian approach developed by this Article draws on the insights of economists Mathias Dewatripont and Jean Tirole, who suggested that bank regulators should act as representatives of bank depositors. See Mathias Dewatripont & Jean Tirole, The Prudential Regulation of Banks 31–32 (1993). For Dewatripont and Tirole, however, the role of bank regulation is to protect small depositors, who are described as unable to exercise adequate control on their banks. See id. In contrast, this Article’s contractarian approach rests on the idea that the rationale for bank regulation is protecting the integrity of the banking infrastructure. Accordingly, while Dewatripont and Tirole articulated a representation hypothesis of bank regulation in the interest of depositors, this Article develops a substitution hypothesis of this regulation in the interest of society as a whole. Under this different hypothesis, the role for bank regulators is to redress the distortions produced in banks’ governance mechanisms by safety nets, substituting for insured and, therefore, opportunistic debtholders in disciplining banks. See infra Part III.B. Moreover, Dewatripont and Tirole’s analysis was largely unconcerned with banks’ internal governance arrangements, which represents a major focus of this Article’s discussion. Where debtholders would offer lower interest rates in exchange for safer governance, regulators would offer lower regulatory costs while demanding the same governance concessions. Redirecting bank investors’ incentives toward more socially responsible risk taking, this system would promote overall economic stability.

Methodology-wise, the contractarian approach proposed by this Article involves a counterfactual analysis of what would be banks’ governance arrangements absent safety nets. “High-leveraged corporations” 13In this Article, the term high-leveraged corporations identifies corporations that employ financing having priority over common stock as their main source of capital. These forms of financing may include, for example, preferred shares, subordinated debt, and other hybrid financial instruments. provide the right benchmark to develop this analysis because banks fit into this paradigm. Observation from the private debt sector as well as the venture capital sector confirms that the implicit shareholder–debtholder negotiation over a firm’s risk choices produces special governance arrangements in these corporations. 14 See infra notes 162–67 and accompanying text. Indeed, higher leverage increases shareholders’ expected returns from riskier projects, while simultaneously increasing debtholders’ exposure to losses. 15Because high leverage increases the asymmetry of payoffs from risky projects, even the undertaking of value-decreasing projects may be privately optimal for shareholders. That is, high leverage tends to transform the debt–equity conflict over a firm’s risk choices from a distributive problem into an allocative problem. See infra Part I.A.1. In these circumstances, debt covenants may fail to adequately protect debtholders’ investment expectations. Hence, shareholders of high-leverage firms need a stronger commitment to sound risk policies than a majority of their corporate counterparts. This stronger commitment comes in the form of safe governance arrangements. 16Recent economic studies suggest that the choice of better governance would be a standard means firms could use to lower their cost of debt. See Viral V. Acharya & Paolo F. Volpin, Corporate Governance Externalities, 14 Rev. Fin. 1, 3 (2010) (“If firms need capital to invest, for example, via a public offering, firms are forced to choose a high level of governance to meet investors’ demand (formally, to meet investors’ participation constraint).”). This observation reinforces this Article’s thesis because the higher the level of leverage, the higher the need for better governance. The distinguishing feature of such arrangements is the incorporation of the debtholders’ risk preferences into the corporate decision-making process, typically through the appointment of a debtholder representative to the board. This appointee serves as a counterweight to the CEO, who, in response to the common use of equity-based executive compensation, shares the same preferences of risk-liking shareholders. 17Shareholders, as residual claimants, are concerned that managers will pursue selfish interests rather than exert effort to maximize profits for the firm. The use of equity-based compensation mitigates this problem by aligning manager and shareholder interest through stock, stock options, or other similar instruments. But it also gives managers their own reasons to prefer riskier projects, to the detriment of debtholders and potentially to society as a whole. See infra Part I.A.2 (discussing in greater detail the effects of equity-based compensation on risk taking in the banking sector). The result of this adversarial interaction between the CEO and the debtholders’ appointee is that the board’s decisional outcomes are less likely to be biased toward increased risk taking, as happens under the majoritarian “CEO-centric governance model” where firms’ informational flow is controlled by risk-liking CEOs. 18 It is important to observe that an analogous result occurs when the corporation is controlled by a blockholder. Accordingly, this Article uses the term CEO-centric governance model to identify both the governance model of centralized-management corporations with a dominant CEO and that of controlled corporations with a controlling blockholder.

Consistent with this practice, this Article suggests that in an ideal contracting world banks’ governance arrangements would be built around an organizational model based on antagonistic information gathering and contrarian thinking—what economists call an advocacy model. 19 See sources quoted infra at note 174. Banks could replicate a similar decision-making structure through two basic organizational features. The first is the appointment of a “representative” of the debtholders’ interests within the bank, for example an insider whose payoff structure is selected to align her risk preferences with the debtholders’ preferences. In accordance with recent international banking guidelines that stress the importance of risk management as a primary internal control mechanism, 20 See Basel Comm. on Banking Supervision, Bank for Int’l Settlements, Principles for Enhancing Corporate Governance 17–18 (2010) [hereinafter Basel Principles for Governance], available at http://www.bis.org/publ/bcbs176.pdf. The Basel Committee is a committee of bank supervisory authorities established within the Bank for International Settlements, whose mission is to promote international harmonization of banking regulations and, in particular, bank capital regulation. See About the Basel Committee, Bank for Int’l Settlements, http://www.bis.org/bcbs/about.htm (last updated Oct. 7, 2012). the chief risk officer (CRO) emerges as a natural candidate for the role. A fully independent board of directors is the additional feature envisioned by this Article as defining advocacy in banks. This feature would be necessary to preserve the board’s ability to act as an impartial decision maker in reviewing the competing cases for risk advanced by the CEO and the CRO.

With the introduction of governmental insurance, however, safe bank governance is lost. Due to the opportunistic abandonment by debtholders of their monitoring function, shareholders have no incentives to put safe governance arrangements—such as an advocacy system—into effect. This account of bank governance dynamics not only replaces the view that managerial opportunism has been the central cause of excessive bank risk taking, but it also suggests a new direction for regulatory reform. Presently, regulators focus on capital requirements to constrain risk taking in the banking sector in the belief that higher equity levels can make riskier projects unprofitable for both shareholders and equity-compensated managers. 21See infra text accompanying notes 231–32. But this is a crude and socially expensive solution, which fails to give bank shareholders incentives to move away from CEO-centric, and risk-prone, governance models. This Article proposes a richer response. It suggests that regulators should expand the set of regulatory tools they use to discipline banks, encouraging the adoption of safe governance arrangements. To this end, they should make banks’ regulatory costs—capital requirements and deposit insurance premiums—sensitive to banks’ organizational features. In practice, they should allow banks to trade safe governance features for lower regulatory costs. For example, banks opting for an advocacy-based governance model could be held to the 8% minimum capital ratio currently required for “adequately capitalized” banks. 22 See 12 C.F.R. § 225 (2012) (setting capital ratios for U.S. banks); see also infra note 229 (providing an overview of the basic principles of U.S. capital regulation). In contrast, banks that maintain a CEO-centric governance model could be held to the higher 10% capital ratio that is required for a bank to be “well capitalized.” 23 See 12 C.F.R. § 225.

The remainder of this Article develops these ideas in four parts. Part I describes the economics of risk taking in banks and the potential systemic effects it may produce. Part II describes the theory and the practice of banks’ governance mechanisms. Part III proposes a contractarian approach to bank regulation reform. Throughout, this Article relies on insights from contract theory, which provide the economic foundation for studying how asymmetric information affects agents’ interaction, 24For an introductory overview of contract theory and its basic results, see Patrick Bolton & Mathias Dewatripont, Contract Theory (2005). and a series of stylized examples, which serve as practical illustrations of the problems therein discussed. 25The Article also generalizes these numerical examples with a model in the footnotes. See infra note 38 (providing the basic setting of this model).

I. Moral Hazard and Liquidity Production

Banks’ ability to operate on short-term liabilities—both in the form of deposits and deposit-like products 26Historically, access to deposit funding had been restricted to commercial banks since the Glass-Steagall Act prevented investment banks from engaging in deposit-taking activities. See Banking Act of 1933, ch. 89, §§ 16, 20, 21, 32, 48 Stat. 162, 184–85, 188, 189, 194 (codified as amended in scattered sections of 12 U.S.C.). However, with the liberalization of investment services by the 1999 Gramm-Leach-Bliley Act, many U.S. banks turned into universal banks engaged in both commercial and investment banking. See Pub. L. No. 106-102, 113 Stat. 1338 (1999) (codified as amended in scattered sections of 15 U.S.C.); see also Matthew Richardson et al., Large Banks and the Volcker Rule, in Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance 189–91 (Viral V. Acharya et al. eds., 2011). Moreover, after the 2007–2008 crisis, the transformation of the surviving investment banks (i.e., Goldman Sachs and Morgan Stanley) into bank holding companies has extended access to traditional deposit funding even to these banks. See supra note 6. It is worth observing, however, that even before this institutional transformation, banks of all types had already found ways to synthetically replicate deposit funding. See infra notes 87–88 and accompanying text (discussing the progressive increase in modern banking of the use of deposit-like products, such as repurchase agreements and commercial papers). —makes them the most important providers of liquidity in the economy. 27While “liquidity cannot easily be apprehended through a single statistic[],” in general it can be defined as capital that is available for investments and takes the form of either stores of value (i.e., cash) or real claims (i.e., credit). See Jean Tirole, Illiquidity and All Its Friends, 49 J. Econ. Literature 287, 288–90 (2011). On the other hand, this same business model exacerbates risk taking. With access to deposit funding, banks are able to carry far more leverage than non-banking organizations. And with high leverage, shareholders are incentivized to take more risk because the downside is disproportionately borne by debtholders. 28 See Jensen & Meckling, supra note 7, at 334–37 (illustrating risk incentives of equityholders when a firm’s capital structure includes debt). In modern banking, this fundamental imbalance is aggravated by several factors, including the widespread use of equity-based schemes to compensate bank managers, high interbank correlation, and the increased opportunities for risk taking created by financial innovation.

This Part discusses these problems and explains how their coincidence during the financial turmoil of 2007–2008 almost led the financial system to collapse.

A. Moral Hazard in Banks

Several types of financial entities produce liquidity. The special business model of banks, however, gives them a comparative advantage over other liquidity providers. In economic parlance, this model is called asset transformation 29 See, e.g., Philip Strahan, Liquidity Production in 21st Century Banking 3 (Nat’l Bureau of Econ. Research, Working Paper No. 13798, 2008), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1092846. because banks raise funds by issuing highly liquid claims, in the form of demand deposits, which they “transform” (i.e., invest) in illiquid assets such as medium- to long-term loans. 30A liquid investment (i.e., claim) is “one that the investor can convert into cash at a price [equal or] close to the present value of the future cash flows of the investment whenever the investor so desires.” Jonathan R. Macey & Geoffrey P. Miller, Deposit Insurance, the Implicit Regulatory Contract, and the Mismatch in the Term Structure of Banks’ Assets and Liabilities, 12 Yale J. on Reg. 1, 7 (1995). Banks can maintain this structural mismatch between illiquid assets and liquid liabilities because of their superior ability to generate private information about specific borrowers and diversify risk among many borrowers. See Douglas W. Diamond, Financial Intermediation and Delegated Monitoring, 51 Rev. Econ. Stud. 393 (1984) (Swed.) (developing a formal analysis of the informational advantages of financial intermediaries). This business model, however, also has less desirable consequences. For one thing, it leaves banks vulnerable to runs 31The seminal model of financial intermediation and bank runs was developed by Douglas W. Diamond and Philip H. Dybvig. See Douglas W. Diamond & Philip H. Dybvig, Bank Runs, Deposit Insurance, and Liquidity, 91 J. Pol. Econ. 401, 402–03 (1983). by exposing them to high funding liquidity risk, that is, the risk of being unable to service liquid liabilities due to asset illiquidity. 32The concept of funding liquidity risk concerns the distinction, recently introduced in economic theory, between funding liquidity and market liquidity. See Markus K. Brunnermeier & Lasse Heje Pedersen, Market Liquidity and Funding Liquidity, 22 Rev. Fin. Stud. 2201 (2009) (introducing this distinction with respect to security markets). Funding liquidity involves raising cash on the liability side by borrowing funds, such as when a bank issues deposits or long-term debt. In contrast, market liquidity involves generating cash on the asset side by marketing assets, such as when a bank sells T-bills or other easily tradable assets. See Tirole, supra note 27, at 288–89. Accordingly, funding liquidity risk “arises when it is prohibitively expensive both to (i) borrow more funds (low funding liquidity) and (ii) sell off its assets (low market liquidity).” Markus Brunnermeier et al., Int’l Ctr. for Monetary & Banking Studies, The Fundamental Principles of Financial Regulation 13–14 (2009). Because of their business model, banks are inherently exposed to more severe funding liquidity risk than non-banking organizations. Indeed, bank assets have lower market liquidity than industrial firms’ assets, and bank liabilities are considerably more liquid than industrial firms’ liabilities. No bank has sufficient funds to satisfy en masse demands for withdrawal because the majority of its deposits are invested in illiquid loans. Hence, a rumor about a bank’s financial instability or a sudden decline in asset value may give rise to a collective action problem among depositors. Although depositors might be better off by not withdrawing their funds, their inability to coordinate, paired with their fear that liquidity reserves will soon be exhausted, will induce them to run on the bank. 33 See Diamond & Dybvig, supra note 31, at 403. And because of their destabilizing effects, runs can become self-fulfilling prophecies and force even a solvent bank into bankruptcy. 34 See id. at 402 (“[B]ank runs cause real economic problems because even ‘healthy’ banks can fail . . . .”).

But runs are not the only risk of the asset transformation model. This structure also leads banks to have highly leveraged capital structures. And this, as explained below, makes increased risk taking the crucial agency problem in banks.

1. Risk Preferences of Bank Shareholders

The problem of increased risk taking arises out of the divergent risk preferences of debtholders and shareholders. Debtholders have a fixed claim to the corporate income stream and a right of priority of payment over equityholders. This makes their payoff schedule concave. This means that, on the one hand, debtholders are largely indifferent to increases in returns from corporate assets, but, on the other hand, they are highly sensitive to declines in asset value. In response, debtholders prefer conservative investment strategies, which better preserve asset value. On the contrary, shareholders have a convex payoff schedule. As residual corporate claimants, they are highly sensitive to increases in equity returns. But because of the protection of limited liability, they are indifferent to any loss beyond the value of their capital contribution. Given this payoff structure, once a corporation has issued debt, shareholders have incentives to engage in asset substitution—to substitute riskier, more volatile assets for safer ones, transferring wealth from the debtholders to themselves. 35Asset substitution is not the only means through which shareholders can act opportunistically against debtholders. Other actions that may illegitimately transfer wealth from debtholders to stockholders include the payment of excessively large dividends, the issuance of additional debt, and the rejection of projects with a positive net present value when the benefits from such projects accrue solely to the debtholders. See Clifford W. Smith, Jr. & Jerold B. Warner, On Financial Contracting: An Analysis of Bond Covenants, 7 J. Fin. Econ. 117, 118–19 (1979). Indeed, shareholders expect to capture the higher upside potential of riskier investments in full. In contrast, any loss produced by these investments beyond the value of equity is borne by the debtholders.

Shareholders’ incentives for asset substitution increase with the debt-to-equity ratio: the higher this ratio, the greater the measure to which losses are borne by debtholders rather than shareholders. This explains why bank shareholders have greater incentives for asset substitution than shareholders of non-banking corporations. 36It is worth emphasizing, however, that the risk of asset substitution may be severe in non-banking firms too. Many publicly held corporations besides banks operate largely on debt, including corporations in the following industries: auto and truck, property management, natural gas utility, advertising, electric utility (central), homebuilding, maritime, newspaper, office equipment/supplies, packaging and container, power, publishing, and trucking. See Simone M. Sepe, Making Sense of Executive Compensation, 36 Del. J. Corp. L. 189, 209 (2011). Moreover, in the vicinity of insolvency, asset substitution becomes a threat for any type of firm because the firm’s equityholders no longer have any expected liquidation interest. Therefore, they prefer “any share of a favorable outcome to the zero return” they otherwise expect to receive. Barry E. Adler, Bankruptcy and Risk Allocation, 77 Cornell L. Rev. 439, 463 n.99 (1992). To better see this, it is useful to introduce here a basic numerical example that this Article uses, with subsequent modifications, to examine the many nuances of risk taking in banks. In the analysis of this example and all its subsequent modifications, it is assumed that there are three periods of time. In period one, Bank Alpha, having $10 of equity capital, can invest in Project I (i.e., the base project). Project I requires an initial outlay of $100 and generates gross return of $120 with probability 90% and zero otherwise. To raise the capital needed to pursue Project I, Bank Alpha issues debt (to depositors and other debtholders) for a face value of $100—with $90 being the principal amount needed to fund Project I and $10 being the interest portion. 37The examples in Part I of this Article focus on the incentives of equityholders (i.e., both shareholders and equity-based compensated managers) for increased risk taking. In other terms, these examples assume away the consequences that arise from the debtholders’ rational anticipation of such incentives, postponing this discussion until Part II.B. Accordingly, the basic setting described in the text above assumes that the interest portion on Bank Alpha’s debt (i.e.,data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABcAAAAQCAIAAAByTXNPAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAQlJREFUOE/NUzESgjAQTHwLUDi8ILxAbKxo7ZJSHmBpZwOlPIHe5Ae8gLEg /AVz4CQXYWQcG69i7jZ7e7cHHYaB/BybnxmAYM6ihFBfU5uJXEhu37NCvxW4xFBdsAkLQKxFiZTI QXID1wWp7z2A+jKhlF7a15tXFyXCPAZWA8yPJXH8hh14R5b3gM4obTRbrfCNtASnc5yHNK1Wt9J3 rYdpvO3ubiCRVSlNynGcDxFHwVQNt2zuURDFXOqsDlecajvUZ/legn3GPJgvynRyCf1o8F6UoLa/ KVnJC2PtDrzJr3BWfXmpWIY8gpXYF84QnCXOKHtagMQsk72LTs+s9xP0r//G1ZtbADwB3WcQjgbr Yx0AAAAASUVORK5CYIJ= ) is negotiated in competitive debt markets (i.e., under a zero-profit condition) and is given by the debtholders’ participation constraint. The participation constraint (or individual rationality constraint) is a property of optimal agency contracts and is satisfied when the contract leaves all participants at least as well off as they would have been if they had not participated. See Bernard Salanié, The Economics of Contracts 122 (2d ed. 2005). In period two (i.e., after the issuance of debt), an alternative investment opportunity may become available to Bank Alpha. Finally, in period three, returns from the investment are generated and debt (i.e., capital plus interest) must be repaid in a lump sum with priority. 38The basic example and its subsequent modifications use binominal distribution to represent the problem of risk taking in banks. This problem, however, can be more rigorously represented through the property of second-order stochastic dominance, which compares distributions based on relative riskiness or dispersion. Mathematically, this can be expressed by observing that if two distributions data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABYAAAAQCAIAAACdjxhxAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAOlJREFUOE/NU8sRgyAQZVOL5pBJBViCd0vQq6VoG7lHO6ACJwexF7LCgiA4 ScZL9qS4+/Z9EJRS7Fxdzo2v019ALH0BRb/QrrEBaMZgMQpRaqh3ZOpBnyvZccY7aV5cYbt3yLZW O4aA1IAA8byFdl8IIsSldccIhh7tNF4s88SrMsOHvnBCl+dD3K94mKqsrPg0a4M0xNos2hwA8pbd 8vRQ7KN4SQchX8Iok12tyfxWJo+Ua57cXSKUFQ2hEDSCpTR7cmNWvlH2SrhIvY3HPPywKNQEU3e1 YvAw7Q8Q9upuXq2sQ+fgL/7UNyC9sh2uJHPzAAAAAElFTkSuQmCC and data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABYAAAAQCAIAAACdjxhxAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAOVJREFUOE9j/P//PwNlgIky7SDdRBhxZ6I1o/XEOwi7tqczMqZvR/CBHoGC bWkI0bRtEMHbE6wYrCbcRihCUgwTZ0AoZYDqA2pDsLDqh5kOkQQbgcMuoDBuEyC6QHaBjAD5AOZy JCfDlGD6AioCtQIYnNs3zGJIC/AkImrQw5GB4di128AYuXPrCoOVlirYBFDggwByeBM0GhKpOmoq YFolvwbsqZnY3eQ58/9/VCmw3ahBgRIsJAQnODwhIA0IoEkCGlNYwhmeDpAiFWeYwyMOQwWSC6FJ C7chEI+ipA80AcZBkVMBQWzQcb3dJeEAAAAASUVORK5CYIJ= have the same mean (i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAG0AAAAQCAIAAACTJmYeAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAoBJREFUWEftlz1uwjAUx196hkqoY8WHEOIE4QTAwpS1UgfTDQ7A2I0lGUHq BZhYSE5QToAYSO6S2nHs2MEJttNWDHgBLPv59/5+H8ZJ0xQeo7ECT6KFJBg5eIyCpLHd/zRwD9iC jknwdl6laYj+TgPiseKWornjzCPLY+8EG+c1HbHvun7Mf5p9oeKjEO9S3EM2j+1DzQF4m9XxjbA5 bkYoSlFcqtvXwQa+GTsiWzNWkm2XXMM/yLyGuxpLFEgNsamSguPSdcer11b/RnBRbJ7XyeVkmVjZ tmi/RbMxtRCfwZt2AJIgiKDT8wZdSA47OlczOlMPlutSepOULw+xMjTELpFDNO/uvPh7wUifX9of Wtg8Hkk6luKRXA3QoM6S9Tpc8xxGoXinIaIJyj7znOa7q81aRKQCOz/Pilx2kpBqYtfpSLIoK1s+ UmR8Jgedl5wR6qPEIJlQm5W49cqKWkdrcrlEX/FUY9/SUdZILsVcGSHyiiiMfcQry7VASv8VOqpe D6Kz1TpakBfRSHMGoFVKwkps6f2oXyCj9XIYbmg9jOaTE6t9SfDJv8OgV18QVce5uJiKY7y5jsui fOkD85VV5EAqLT8d12qc0l9+W/MEV9Sx7EOm0X4Wou2+8nGH+8Bk63IZhXbSWSzyvgNAsE6X4nWv Noub0XForr0C25yc6nXcHSgkQUGzd31sMa+lCkYjO3+yENNyiWT5hkK2kKWCqh/R12NhTGnWosuU Hy3sIWxGziJeqCGum73W9LGZjlZO6LWCfNWNJmIHYLfLhFsTG3A5JsqLrcLkGLO15MYV/1oqpmtt 3xk25Olo9Z/MTMRfXX1v2A72TrMnPZbVKPADzn8qU4VhR84AAAAASUVORK5CYIJ= ), distribution is riskier than distribution if data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAJkAAAAQCAIAAACKgUr9AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAvFJREFUWEftWD2aqjAUDW8tOMX7XAGuwJnGytYOSlyAO5hGSulsrWiUFQwr 8LMY2AvvJiHkBhIgOiNv+IZqxlxzOefcX52yLMnvMwkG/mAURbRw4FlExSSwWYGYAHakZRFtbruy vPgDOaDo9bKngeME6cBrBpl9t69pYIcay59873n7vP63/gNpK8/BmGit8de6DahD0NG/VF9pxZA4 +QpfbVjKJ2NjZy+DCbgLO8Hk17yq0KkT5cgEXf1avxVYoHupZkjZKhL6bzEFYuu1zYKC6fjYxStI Viyx11oqTCLUGpjDXLBMN1HEHVx8nLrgqZ3JD/qqYn1AhdBp+Szshspji73ul/kt03Wu4vPq/Z0p J8X5lM1f3PozPjWw/kgbpeyU7tvau3625ihmRO2CJEb3UE/rN7gW7qub7aO+lgcWNEey4S71TXxk 7On7NvN3oWSUU2uNXZljNWK64W6+nXXwQNIzOUIExUkULZIVEHdYonuyW67cCkK+XnlbXpHYX9W2 9M0z5mm2JY3oqW+w8yUdu+EH03SV2EzpT8KeJjFBRJhmwX7sPVpCjrzGvPwoEiGHyzB0aQbGJ3I0 2UgxktjbH1kINjIecoNXwnzvs/TUPVa+8AVVLaCx9tFKAAN7T8IOPBBR+qrFSFs/+rF3apkGM7ql 9CrUsVaoBRpCkNdRVkEI0kyeuOFhKNsNv81mIIo+5DorGFZInoidENFqoBKwOdOecYoda9lqjBAx mn7XaoMQTRuy9rPTuSiiSLakZsFH1ANTW9p004C3MBqcuAcL00d80VysNOwPx/Gwuy9zEicVa7je 2mMXI6t+LOc7YHMaRQMqHRR5bWQjIx4YdWOY2KH8C94u5aftteF+X+YVpHkyJnZ1s/ThEQu3sggM 4VnsJJ3zbxtr77ph/OlhOMPC8l5fhh+wLPeeH4SdQD7RSFBXvUFLvwwVTZz3/Cpkq+g3+ZoWdlJV UeM2PXRhtVXnf7CfGHYHOO0YQ3+PfhAD/wC7QnpX+idcjwAAAABJRU5ErkJggk== , where data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABMAAAAQCAIAAAB7ptM1AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAOxJREFUOE+dUjsSgjAQTRyPAhaMJwgnYOxt7aDkAh4CSu1srWyEE8AJHArD XeKGXSUfMuOwXbL73kveW66UYqtqswqlQWHkWKc8rUdibgvOi9aSUU3ORCXh0UbJSviXziSDeT1H lTd49riQ1uxoJJCZk2Egikzs4KsnYTTtLziq4FBUdjd24lCzIbMVvjX9IMlb6MXDWTN2ZfR/SFvW Pq7wyywEyS7uqogkRs04EaSP4OhwFK/3N0eHcHze+/0OX0Zm4wTaFvbIS4U8hJ0gx5exdlyT5i9m Ak5n4DH2yD5Rnt52LMS4cMX1NqyqD64ApUo4aVM8AAAAAElFTkSuQmCC is a concave and invertible function. See generally Andreu Mas-Colell et al., Microeconomic Theory 197 (1995). To this extent, second-order stochastic dominance better captures the concept of tail risk, i.e., risk that occurs “in the tail of the probability distribution.” Rajan, supra note 1, at 137. Indeed, we can say that data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABkAAAAQCAIAAABshEP8AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAOlJREFUOE9j/P//PwOVABOVzAEZQ4RZdyZaM1pPvIOwdHs6I2P6diyOAPoR CralIaTTtkEEb0+wYrCacBuhCEkxhjgDQg8D1ACgfgQLq0Ewa9AkwWbhsB0ojNsoiC6Y+8Gmg8wC eQ5FEOFWLMII/6LbBQz77RtmMaQFeBIRoZiBfuzabYQ+JoY7t64wWGmpgoVAUQYCWGOJoGWQNKGj pgKmVfJrwP6did2VnjP//0eVgjkCYg9qcKEEHTlhDw58CEgDAmjSgsYvztDHtAmavjATI4G4xOZm AmaBTAS5GiWdYQhAXcI4SMsJADSMGDjkRUNbAAAAAElFTkSuQmCC is generated from by taking the mass from an interval of the distribution and transferring such mass to the endpoints of the interval. See Mas-Colell et al., supra, at 198. This implies that the examples in the text can be formalized by using second-order stochastic dominance with discrete distributions, as in Bruno Biais & Catherine Casamatta, Optimal Leverage and Aggregate Investment, 54 J. Fin. 1291 (1999). Under this more rigorous rendering of the problem of risk, the basic setting is as follows. At data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAoAAAAQCAIAAACgHXkXAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAJtJREFUKFNj/P//PwNuwIRHDihFFent6Yzp27HYAzF8+4ZZVlqq2Jzx//YE K7i41YTbQJ8gAQYQe1saQ9o2VHEoD2T4nVtXcBgN8tidrasYwrxVsAYAUPr2tWM6akDZ7elQxwO9 YT3xDlg5UFpVy2qWFyMj44aAmZ5AsyZab9CaoAMzC5uLbk9Ig3qBQKCCPYYCYOEADgNG/BEKANAo fx/6scEnAAAAAElFTkSuQmCC , Bank Alpha, having equity data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAcAAAAQCAIAAABV4/KnAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAFRJREFUKFNj/P//PwMGYMIUAooQFN2ezggDDEBzYWBbGoPVhNsgHpIoQhBJ FCEIZCFphzvHCiaKrNJqAlQUyUyEbSiCtycATQARqMBqAiM1wwHJcADOMHnIAc46DQAAAABJRU5E rkJggk== , has the opportunity to invest in Project I, which requires an outlay of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAcAAAAQCAIAAABV4/KnAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAFJJREFUKFNj/P//PwMGYMIUAooQEN2ezsiYvh2qE6j2zkRrRkbGlitWCMOA oir5R4FWLgxDsoEs21BcSIoJDEDrb09AchRD2rb//xmpFw4oLgMAvJsYmrX15sUAAAAASUVORK5C YIJ= . Project I, as well as the investment opportunities that can materialize for Bank Alpha in a following period (i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAoAAAAQCAIAAACgHXkXAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAIlJREFUKFNj/P//PwNuwIRHDihFFent6Yzp27HYAzF8+4ZZVlqq2Jzx//YE K7i41YTbQJ8gAQYQe1saQ9o2VHEoD2T4nVtXcBgN8tidrasYwrxVsAYAUPr2tWM6akDZ7ekgxwP9 AAEQn/yHuw3F+m1pYGeCnYYBoJJYpZH9gaEbKAkBYMMZ8UcoALiapZZFENmYAAAAAElFTkSuQmCC ), has three equiprobable states: a high state, a medium state, and a low state, with the following payoff: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACwAAAAQCAIAAADiXgqAAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAATRJREFUSEvtlc0VgjAMx4truIDP5wRlAhdghDKBGzgAXBnBUy/CBk7gDXbB pk1KirRyg4M58CjNxy//tI9sHEextR22BoD6e4Poysxa2QFduErqha55PUxu+M3lSpj1E+ZMkLVK CNXSqq8kWzG379dWSSmFrHqeiedKRENRNo5ON7K6XRF7eD5e6qizoL/lljr9LoqL3xvqXJ9NB6fm zrWJxZqikxIGifXidYAXMLY368voUPXen6/WxEJiDwGyhDZNBqpSwvCr2bBV7bZqzRP255NMxNrm CCKiw9L8Q1UcA7BACxYxeprAhytKRRFiBQO2M1OCGAAC8y8wxGIxxEGkGGhOi4fCM0yScYYfsYQt /LDxPlKc7Ti8tPPZONcAjkUnY+mUuFOY/f8deB339u/Y7n/6AeUgyerqewP3AAAAAElFTkSuQmCC . Project I has a positive net present value: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAGIAAAAQCAIAAABiLT2TAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAkZJREFUWEftVjGWgjAQHTgLWvA8AZ5Aaaxo7bDExm5LOxootdt2q21WTiAn 8FEId2GTQCQhJARki/WZSmJmMvnz/8wYZR4tQ/AA3FNgwXt1I2CCFVxP7hseNQJmD0BFvDSWcfFv YEx2hrFLpg+3RKpziFsnyktu4T+azYvPnKI2/oU30fiq/bCWlTfhfg1nJRdVbYD2Rvni76s9V65A GguKnb+MRw1/yUBCNyjwyyPf9xnffSD1eWNzWb9GiF0HceEMA7dUdMXPF3guW9TzLHWaHfTlb1Zj 2J1nYNuNYRJmHsoIf9cgv6Kt5XqwD5/UXnG/PcKQwYRQShdzFiVs1ewk32fHng16TX24uIPtzhdp luONZHe0N9C+S9+vGCexRTg5t3u7pOLC1bEUtbd+cNFXwh8B43jgvKa3rM8j849ZOrdmNnlFEX/b nwEgmo6DHEBB6joRDOSrU6f4rj2TUBFvzRa60jxiyTU1HsmW5xohRoMhA2grV3m2oFrN4222CSxM TFFyet7Gk1qbsAik7ENWwtsVmu8e6qqK24+8uldgkz5CDql6AUm+whtbqtFv5tLOIk6bVwsiSVsk T75EPo5XJrqWuKcqTCj7FQuR6pzogFoAFvMzkqOkTsL9g6aVV4HuMFh06f4IByJJ1UBAOUGzUGWr a1QRRo5ONokjk878JWMTtaXcYEgxyUDACkgOk4YcZBD3aHLgEDPY2yQg8UGqYKLUmWCkHYjM+OOY sH8QL1AN1QV1fIAvbWnSuibpAtp987UP/gI2SeKVXdM1/wAAAABJRU5ErkJggk== and data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADUAAAAQCAIAAAA55aCiAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAUBJREFUSEvtVjsSgjAQXTwLWjieIJzAzhvYackFvIGNlJTcgEpPoCdwKIS7 xGzIJgHCz88MzrhVFjZvX3b3BTzOOUzYZhPmhtR+ht9l70kLogJ5F1Fgu0OqjAj7y5DIjhjKSzxA zJ+y8w7YKScvPzHLM1GulYgVKRljsDt3R/a8FRRKCESU6Q0//QgxhDM6FQK0bKoevZWkHabW1flb LfyyudvsEK/fbJW1fR3zBLZ9A1M87pWUtyx36ePj7GRSP7zKuhHPlklVFQKYL3Fmmvzq7Eg3pXq0 KRmNLzHx3KRaizbI/SHlqc30N89ubAnREZJKZ0VrXHYN5SS8YEqh6YbzGoi/WBk8SWcORh+oHVvA o4XYoQ/Ekvg9Kbr0O1BjTtrlBUPWFLHO23toOgXdBN7/+/vCjLr08RbM1zZP/f/gCREUgbOMFuuL AAAAAElFTkSuQmCC . To raise the capital needed to pursue Project I, Bank Alpha issues debt data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAgAAAAQCAIAAACk6KkqAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAGJJREFUKFOtkNERgCAMQ4tjMZDzMA3LdJgYjyqpB3/2jxfS5FoA2GqOJSXc CsZVMf1M7imASm0+QM+Ol7ORbhI+Bd3Dz/44PpzPyJJcJt/9RgftQ8owg7ea+keD8t+ttke8AGgx ocClKydmAAAAAElFTkSuQmCC , where data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADYAAAAQCAIAAADS0huhAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAARVJREFUSEvtVsERgyAQhNSSySsVkBLyTwnajvmmirykGNMLAUG5OxBO89GZ 8BI8dvfuFgZpjBH7Hqd9y3PqjiVRtxKNVm+oMAWRcguMQ4n7rBen0TdCdYOf2W8hmh78DavJWhoy g5ihU7V4st3usMRKqUgu8gq9xsgVouxihRKmSdhXTJ3QmSh6Ub9f6nE/w+ZeL2jK6HsE0e3t+QE7 UgeMrsJBeYZcl+0aygNaoVjF0R5hJC3YWsWp0aRBjmsWA4lBnqmGCNI3vyjEBQoSsUIkECZf9mLR h+w8HR/qoZdIz/JSCYoSkcL1ZxmWgkj0x5znoUWJFCRzGzCtiJGc2cClw8CoXzoMkLUh8v+MYNyl tZADPCO+XsNNLf7+a88AAAAASUVORK5CYIJ= and data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACoAAAAQCAIAAADvQHrHAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAPNJREFUSEvtlc0dgyAMxaGTdA4HwiF66gYu0DV0GIdBCQTy+BAv/dFDcxLL yz/hBauttWpcPMahHfl38NusKebN1YWryzPirV7OCXrHSip1es+xGqXMyqt9mcRKbCsfT+G07P69 S3JPRzuBHpNYS/S3yNsuQNID//kK1XRUCY9JYu/uwYWoLEuJQmrffG6qIp6OAiL54HhcBr71py1L Q896KsY3eq/6DLha73F+YKxkkawK+Bv00EjWfel79dBaKo+/orMrVfPzmccL0BqZpFLR1HBbmEb1 4lXMnGBfeWAAXYyIvM9pxPT/m9/7Pn7v98F/OQciRf46yCgOaAAAAABJRU5ErkJggk== . Under the assumption of a competitive market, the interest rate, data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAsAAAAQCAIAAABP3xIpAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAI9JREFUKFNj/P//PwNewIRfGiiLU8X2dEbG9O34VDAwWE0o9cSj4s6tKzpq KiAn4LLl9jWdAJAJQPD//7Y0IJW2DcqwmnD7///bE6yAlgAZIJ9OsErbBhQAAqAqIAOkFAUAzYBo xpCBKQOpABkBNRJNP4gLdOmdrauOQd2NNfjAduC0AmgGIy3jBe4kwnELAHP6lmlQj99tAAAAAElF TkSuQmCC , is determined by the following participation constraint: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAIMAAAAQCAIAAAC6DVvcAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAthJREFUWEfdWD26qjAQja7F94r7uQJcAdpYuQQotbndLe1osJTO9lU2D1Zw WYGfhbAX3iQkkB8CE+Xej/tSAU4y58yZTCbOqqoidGTh6vH+uV+wl/9/lKdVRHaEbM5ToTyvg56F x7fLVDB9Rx4s9p/nzXc4QvugSmTh7LrVtwMkzYyNMMMtRiesTiXO2NEKENY4mgeRQDXGsf3auWgA HHn0mldpwH/34gJKlRhF7KkfGjtmbhirX6hxkErLvfaYBpI/WFvxrr/jXAG/DiIwl/7Qrs9Zj+DQ hKVGlNhwG0owiDy6jEaDTjGtGXpeY9vlADC46ARrKuYqtj4lHB0xHQaSjPIxg4OTX7OSkaf8nEDu Mu/tF7Nc7C+xl98L9lL+/UN2G3HUQwEGfxc4DMcbxX259aXlFpsdOUTIqukEQ+UiikXLjn8ZB0B2 TbxmaR+vBIDMl7/l3ur2oKeC+d2Ju2ZM6zA7EtgDq//l6ZjUrpoBkfC0T684beaaXCzsugEwzOaw nGKKEITglSjueaBkJlF1GSEUcFBet7Dzb8cV9BDwwDzQXdbRXostOYLfniVM1o2xCcA/dxap7ruB JkQ51yS0gqITeW3iG0F6xUWjTZl1QpK18NymDG0tfeCeLz+qs8/ecCt3bSy2vMUReY71U2AskzQh smiuqWhzVj5ubU0jWXTIgw/X+0ebMspBqqYMdRS/IxToSYRhR0+whg2rNvQmAIfqpAqRhesEW50g U0UxAn/rJEhFvo5bs3GnDs7KPYV1LjLr6CC1Dd0A8NVJFoLG8xYXqC5W9N6cmt6ASu0t78fbGHQ3 q/bmEtV2fm0Xq7TqkppSd/tSF6tFU9wGUEoMNsuqFoPm9Dbpcp9QF9TDMOp9or7Z9YN7SQdrcPqU qPMBGzJ6Y1QvRcOKOFtoTsQtdWy/di5fx5K0/3ZgQ+4cvilOaP5pmAzrOeHHjPYniPtp97NmTI/1 P40de1fHu1quAAAAAElFTkSuQmCC , from which data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADMAAAAQCAIAAAA0+9DlAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAT1JREFUSEvNVssRgjAQXa1FPThUgBU4XjxZQjjahAXIUavwFCrQChgOQC+4 G/IhTAIq4LCnDPt72X3sBqrRhTPGZVDOwmtBZ31wZrO10n8JE0qZp8FmZSdIooWRXVyi1mUG4EVG EaLkF9jrLeSUEKDIguOeDskjPR1qiPtbo2zPM31UZklMQMsctmuy9DWzu/7dFKj7UVxDdTHdXoef MROd11zwIUP7rnB95OQMJMP6LJt6Aqmz+pA1aPxN7BFtkWeCk0QpcRCkLOPLPZVkaVDNYm+bx79Q stOHuoZVRMFCDuzhiBWrKtFNZIXp79Dwo9UOgVDJ6oHYI3QDh3zm3Be8rceaWX/Et/7T2eMfUGQv Vg/EWckCLz0rQBrMpHtz0JX/gkzPQbWIzWD0r+a/IJNbnDMzvdXrCC7iueGQN3v+c4eTuimNAAAA AElFTkSuQmCC . Finally, data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAE0AAAAQCAIAAADce2XOAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAeFJREFUSEvtlj2WgjAQgMOehd1inyeIJ0AbK4+AJTbbWdrZYCmd7VY2CyeQ E/gohLuwkyExRAKMsPvePt+mCmEyk29+MnHKsmRPNZKVM4saRM7TcdqD9kKKZbGfOtN9QZIdIAQh cFYJbLxNBijp2QLxLMvYr0vxMMfVauQhZ8aKEPbjmsToaezXDIB68wAPqrezMA0jzy64tCX40lbx F+Oc93CCqUccAWoNccPmg5QyMA0Wnbf8/RWD6gbHkKdZjh/F1ydbzl0ZbTc4g57j8oezKs8mC6+m 050v2Xon8njoaLJUnICTTt4Ujli5XEU1NteHWpb7RAFiKeIES77Yb6PK2m0AKL9bQvnmsFwadpaK M89S33ApM6lH0sntcJudFpCUl+3UwQkaEUlyDuo+RnGVUXKvd7AmsGWjnQU5k1OkIi2DWPskM2qX Q/+KZsr52uVAdPDgGOlkUx48/CIrJwu2sAjO4nrhugiT3Tr1N00H91rSLjfuIdPlwlb4QeC78zQ1 b9tYBCe4WKUpPib8WDnaUii9uJ0CtIK3SFHztpWl6hW3cd8PxG+9Zgq39o72vkLqOIP7SgeL7J8d XcokJbUzEk2bpsGUnUfr51TvpVGPFJJ7qnfZ79j5f8ePu3D+2u5vQtLaGOyjQM8AAAAASUVORK5C YIJ= is the face value that must be repaid to the debtholders at maturity (i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAoAAAAQCAIAAACgHXkXAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAI9JREFUKFNj/P//PwNuwIRHDihFFent6Yzp27HYAzF8+4ZZVlqq2Jzx//YE K7i41YTbQJ8gAQYQe1saQ9o2VHEoD2T4nVtXcBgN8tidrasYwrxVsAYAUPr2tWM6akDZ7ekgxwP9 AAEQn/yHuw3F+m1pYC7YaagA6FAGBqgfsEiDFUM9gyEN1gsCYMMZ8UcoAN4Yo4WsBnbmAAAAAElF TkSuQmCC ). Figure 1 below summarizes the timeline of these actions and events.

Fig. 1 Timeline

Since this first example focuses on the different risk preferences of banks’ shareholders and debtholders, 39The property of second-order stochastic dominance perfectly explains the risk preferences of shareholders and debtholders: debtholders have a concave schedule like , while shareholders have a convex schedule. Therefore, the following condition applies to Bank Alpha’s shareholders: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAALAAAAAQCAIAAAA5yWLnAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA2JJREFUaEPtmDt26jAQhsVdi0lxDyuAFZA0VLR0pjQLyCJwiTtaKhriFYQV cCiC9+I7etgeySNLMuYm5wSqxNbj1ze/RiOPyrJkz9+TQEXgD0ZRpLMR/GZp8QTUIvBL4CBDFOnq +l6WH7GnGzgh2jv5ejRa5+5hoN1Q5rtfTLfc/w8H9HwLHzgy5O+2nU63t/rf+g9kkOY9NGZka9yt uwEMEW+3MTVlI4LPw1j8oZ60zCreDCCmvWz9iQ0OtGrzGUZPHz76dq6wBelhOII1eJ0GX7L2qgMP 6qm10kJZO+XmMoSINpqbrw3Zgw/UQ0xn+El8IN8CR1miedtPzxB8xO5RQhpsgXpqQ2ioETEChd8U cufaMcqs5MgQ3PI40YAaI+8MJ0bFhMprHSsx+QynJ5CPJQ+E6qkN0UoD1oPEpIPSumDqu1lkP0Ye PdWGiWNta9arqzfAAGLquaqDiT42aWubvAfQg87wAD72+Gmb0hks7ZZB1FVR8j7ZjPndw1Yl5ie2 h2myY5rOjgtYzW6Oxjlfb7ZqLUo+xdo/k0hvArXU60XWFguWxYt6vOJ0OJ+FmvGG/R0TA4eK4eWv EG3qdlfEsoWDT6gePG0Qn/yYMUTKJt+tx2EIKN5fM7k3tDijCedJEkVvy2l2YHtbG1+8oh2sbbrd C5cUX5cpCvztepYJHY6a5ZthI9E3VMx8B6Y7cr97XYuou2gnn1A9PqAoPgCKVaTU/ZhckFtPpyHy 9ZhfRO8JM46nz2qlH1S0ISMwFPjmTZTszLTiMzgthpuCJyPpi5CL8L18wuGo/ULymbzILQJJS9wC wsPG9WBDmPq47S5frY9UPB1oj8GSK7aMz4dTUaRp8/2BZ/hKpU+8jDaAe8P752t5WnE5reGGE6N8 Ue7ZijIFETyKz3B6nMQwn+hlwrKjQo+Pj3A9VQlDX6xU4WcUVKhy4rWMTOOiNsMlum99a9ZwTZGH KqD6ut+q7R4rRoqz3joJPg/XQ/NB30OgEqdv6j7Bqm4ZndFr8/C5UdLfuTq/AfR7eYcYy2fZwKut wecOPf0AOHoF6WHgLG4n/bqvz2AxS+M3ao93f6YcfOEPEuOGI0rctvcfpKc3N289TCU9a/z6Jv7e 0n9SRxccixt+0hJCtYygg7N8eTb4PQT+AdIOf8YRMySfAAAAAElFTkSuQmCC . assume, for the moment, that Bank Alpha is run by a shareholder manager. Further assume that Project II (i.e., the asset substitution project), which generates gross return of $150 with probability 72% and zero otherwise, is the additional project that may become available to Bank Alpha in period two. Note that Project I and Project II have the same net present value: 90%[$120] – $100 = 72%[$150] – $100 = $8. Project II, however, is riskier than Project I, since its standard deviation is higher (Project II has a standard deviation of 67.35, while Project I has a standard deviation of 36). 40The higher risk of Project II can be generalized by requiring that the possible realizations of this project are as follows: the probability of the medium state is reduced by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAE0AAAAQCAIAAADce2XOAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAgJJREFUSEvdVjuSwjAMdfYssAXDCcIJmDRUtNs5JTR7g+1okjIcgYqG5ARw gh2KTe7CSo4t8rEtD5MKVQbLkp70np3o8XiIt7QmXx3EVoik2M2E+HhLjAhqtrsWCaHr4IQGRKu8 8QGv0ihKK/CgxSRtsoadNoUA3oLVWSzirG5/uK2U2okW3Anbfil1d0xGZ1jwDKjKUQNiQlMRFE74 Jygc+MlSH2gXFoPanHvgjiApSLvyhQ0tjes38ra5nMQ2AbFyVt+XmzU60YI7Mdxv8p+jLAsVBFu9 mHejWcLOkq3YH1AqXuM113J2MAHDLJwyzYe47Se5d57PTZorF9Y/UV0pS0fg7RAnHm3P1ZmUUlOV Iwbt+3C2elPC8XG7l8syBk1/nHBomDHOjvbtKVyqtBGr3+fOaMJvmHERT4l7mj+oZvR+VudjrMWK us2+jZb8AlkXJmdvnld8o8nq+2352f4xX8S3e83JridjcsZcm3OEph45qw1aADhB6vHv3+jdrNKv E0Zo8py9BsLqxRaqiwfe38P+ZtbMDXM5UXM6nrqvGq4HrzljXk8iurmD4A+1ZCU+6JxTn8hakLtO HCiswHfleac4qNz5TgjMzF1ITpwvfFsEouRKgn2NEz3ZngSE87jQ10BgmGnL6eAMzP+i23SjCSyA vi4VTyOc6TtblaaiKNb/MXeOq+ccagQAAAAASUVORK5CYIJ= , the probability of the high state is increased by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAA8AAAAQCAIAAABGNLJTAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAKFJREFUKFNj/P//PwPRgIlolSCFBFRvT2dkTN8OVAdhEDTbakKpJ9h+EAO/ 6ju3ruioqQCVQhn4Vd++phMANhnGAIYJEGxLg/jWasJtEDttG0jw9gQrsACCwQBVChYFCqelpVlB 1GIDQNVAsyBqIYbgVguMGTTFMH3YzUby5fb0+FUgt9+ZOBEUwlgBwodAJ4A9i8d4xoFLJ2iOJ5hO UNQDALZgyaCLPmvWAAAAAElFTkSuQmCC , and the probability of the low state is increased by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAA8AAAAQCAIAAABGNLJTAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAANRJREFUKFOVkrERwjAMReXMQihymcBMABVTOC0NG9DROCWMQI+zQSbgUuDs YiTZziUH8RkVvn/207dkWTjnIDuKbJLAFN01QjQdQpOY0bTHsWvHcKPU5z3LICKN6AEMNuGshtOV HMf3q95u5iJUMraXuzI374NOVYmrHeoj70wCgOycUaDYmJSXVku8384EvV5A8IDOYxJnfgfRiLGL t47yF01d2qH37QCUlewHuz6DhR9VnfIGrkMpLJkjNLtat1Ept2VaMc0g58MUzwfwLLJC/PVjP8/4 EGGMT8XKAAAAAElFTkSuQmCC . Accordingly, Project II is characterized by a riskier distribution, which is dominated in the sense of second-order stochastic dominance: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAIgAAAAQCAIAAABC7aArAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAx9JREFUWEftVzt26jAQFVmLSeHDCswKEhqqtHSmhOZ1KelocBm6tKnSBK8g rIDjAnsvvBn9Jcv22ORweOdFlWx95t6Z0R1pdLlc2G+7Pw883B+kX0TogY7A5MvRaJnDPN0xbquy 6WiaVTfyYwDAD1lu4wgmbkXTJwhS1tIOabIrcVx3xORylzA5wge5j8QPHMKWHtq3DozKfeyVYjcN wjLae3e5QBrRmxpqHscmmo3w+iFynGawKa+y1t3ALQKG7qiwmKjU44TOHBAWbiZN08Ts7YRFGnIt 93MGTyHNSPQaOIoRn2YHvF5o3OSWS7XNdikri8n8CdNfd/Cj+vpgL7PIUpKyOCbmD3ylYlnfVhYs js2ifFu8gHMsW9Hsha23qK1DWpVt9unhTUFL4rFNzeHYQLMDXl9QNjWxVhOUgUGBw4Y1A/q8rIC6 bvanMxQR3eFrIS7HyaMdl+p8YuZP/rkXlHu36szi2ePkWJS4NF9u4jnzbAHwhGNymoIvSOjmV0CT MflyvJ68rqImjg00O+H1oFx3o4qMIChLhKoPeFY7ZKimVKqqaFQD1UaIijzMoGpQskB6vM2G66Tc jKMlKG2IZjc8upgBtSAKaRdODGb47h2yB9tpz171WSfGH4VMXBGwgUH3PPHk93LZnE/LhqUlZbYo 5qsIobmiSYQUmgbnGjeLVt+XA3vuf5+kwqOR7dKVBx4XSR6Lx+5P3+rgeg++6gXm6S2YSd8yG4Qb 888TKmAEWrZ+LjA9XIk0B7ImlCRfQP6ojBnHidRLeqDJ8EhkZZaI2pBNRe1QDSuBVfzz5eJDzMta q6sn8z9VYCCiwm/gtYSnB6qwX63CykzxhZWi+XZd27gWIY8mDR45zlaWABp5xeLeVxVcv0JQ8fjd urtCWPKrXgVCLkN3c5rq1p8wwfdQ7QZL213efaF+Ss8Raox4kcmJRHhENH5RtjyuCba/YxoNXVGC ieBD04aHpfZCpqG4NU2L4MDAqOPRfbpoHuiehTl7hTX3hdxtzsy40jDZlGdnBAvJwvjvToT6umDv 7mXjvtn8J4G57yCE0P0FPKa2CEWSUnUAAAAASUVORK5CYIJ= . This means that Project II is more likely to jeopardize the repayment of debt than Project I. For Bank Alpha’s shareholders, however, Project II is more profitable than Project I because they expect to reap the higher returns of Project II with limited liability for its potential losses. Consider the expected payoff to the shareholders from the two projects: under Project I the shareholders expect to receive 90%[$120 – $100] = $18, while under they expect to receive 72%[$150 – $100] = $36. Hence, the shareholders always prefer to substitute Project II for Project I as long as Project II materializes, which will expropriate wealth equal to (90% – 72%)$100 = $18 from the debtholders. 41This result can be generalized by observing that the shareholders transfer wealth from the debtholders to themselves for an amount equal to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADgAAAAQCAIAAADMGysSAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAblJREFUSEvVVjtywjAQXecsJgXDCcQJCE0qjiBKc4CU6WjsEjraVGlinwCf IOMi9l2ItPpbcmzBMBNUrXd23/7eLsDl1ldSCDxa3orb80/YdyjQv9M9/ZFRtU2SbcUMtGCMu2KZ LIvujvX0g5oO6xmSvEVtSaWkBWHc5gSUDbeyszX62NFLHAeA6dQ3SDxuJnjF00CJCVpjUY6p3Wy0 g/C1aojL1a1f+upoYvRd8X6k5WEle0PmMya1zeIVNVpA068P2KxTd+bCASDNTjmpm/ZaRhAPOV1v YLfn/JNDlu3EQap+it64hVrtMzUrZ48WMS31kTXReB6YqKACzm3srPhwzNklxihGOH0Xx9jIiHz0 3c8373manS8lvETucvV5VIMXxKitT6QAX9/A68VxcXzu8ETbpl48C9bN5pEUk0VK4Gq/q+lb5jJ4 dQi28OyY2Tjs9OFV1A9LV4NXXB1b2t7SWwPD+zJGnSHWujgBLgFfFkIpoye+8UD9a2QKH/cdSBO3 w+6gPORiOcUxBHPWJ6/o0H5OBphsaI0P9Fmf7D2VJHGAnjVnkvXLkrDWwskl9rXn+q5+D/Pv6Rfm eFzU7BaAlQAAAABJRU5ErkJggk== when they substitute Project II for Project I. Figure 2 below summarizes the essential data of the asset substitution example.

Fig. 2 Asset Substitution

But the transfer of wealth from debtholders to shareholders is not the only effect produced by increased risk taking. Instead, this problem may also lead to a reduction in total wealth. If leverage is high enough to shift most of the potential losses from these projects to the debtholders, even risky projects that will reduce the total value of the firm can still be profitable from the shareholders’ perspective. The following variation on the above example better illustrates the difference between asset substitution and this more severe form of shareholder opportunism, which is referred to as excessive risk taking. In this case, assume that after Bank Alpha has issued debt to fund Project I, the opportunity for Bank Alpha to invest in Project III (i.e., the excessive-risk-taking project) may become available. Project III generates a gross return of $180 with probability 55% and zero otherwise. As with Project II above, Project III is riskier than Project I (indeed, Project III has a standard deviation of 89.5, while Project I has a standard deviation of only 36). Unlike Project II, however, Project III has a net present value of negative $1 (i.e., 55%[$180] – $100] = –$1). 42The features of Project III (i.e., higher risk and lower present value than Project I) can be generalized by requiring that the possible realizations of this project are as follows: the probability of the medium state is reduced by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADQAAAAQCAIAAADWJ8ucAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAWFJREFUSEvNVbFxwzAMpDJLnCLnCZQJ7CobpKNaN97AnRupjEdw5SbSBpkg 5yLiLgwAkgqPlECJ50KocCLw/wAIqtBai7Xa01qFoa6EuK4qiqqDuNh5VFUMRbJzZX3ckY7YyZKH WsjeGmUBJil4cer3Z/vyDBixM6IMeKnL0wYRe9HCNdd9LQ5nDOYoeHH9fftOfYudjLap5nSR7acZ BIzidTOKPHAJgWVo3UqbUPfoS1tdCcPssczQMVmBDYmjp0RigImO3Bh5+ILPiA0lERArpSwtwgTF 9OeEODgGFiR3GlMMIM4kUSBmLpXmmh7M2UEOAgDbffMYWX0i0BZhpqrzzvnOeadze+AtRFd9XLF8 1TT8zmXsAjyUt4vZAHDPh2/n81j/ywDzpBFlN4/rHA4VrrPVMvPq2G1dMLy8hWhlRs2PFMdUCI2b 2S0fJPn7yrpgYZL6ugp74ZbgFfjWrdX+AL/mC+BnLSTpAAAAAElFTkSuQmCC where data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAKEAAAAQCAIAAADxpYgxAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAsRJREFUWEftWDFy4zAMpPwW54pMXiC/wOcmlVp3Upk094Pr3Eil0l2rKk2s F8QvyLiI9BcfQEm0KJEUDNNOJmNWnBGAxQIkACo4VOliIyIhVvnTXNzWD4zATMyf3vPVD2R2o9RF YOYtFHW2CBZZ7bJXJkGQlCAx3vhygwKhZDyAslh7wHXGcEjwAMU6lKBhWh2YC00Q1LdxKzTeMIG3 cRuvDp0KAYoEh91esVlzyBKYamZ7BOEeQ7GWX9+5/bjO1kVUTavXnx8Pv7Dnjzfmkw3nUV57y4LP v8UWXa9S8bxBSTLEMq+iYu0uO+7rxmdtsOuDqW62R9BRqwF3ovY2Vuu3QkQrwrxW7R8el6gx3jCq V539fYm3uTSIVej+zmhZYQ0h5quoPRjalyuwPpUskamdoLNuUMo4ysTyNqnV1RWshrBvvqrKNt7Y fFC6JoHjR4STGCdCgLixXl+WtZHs+UxNZluCgtQbOtaDXErdYY4x4k3oqjSO49CkQwI9HM+HQb7p N9IxLoLhdGpAV2TtyjGfaUtweMHd0T/m7yg3iFSv10/F0IKlpgvdN/3K9e4ge3yi+ncx1pdm2hKc DQJt6RX4RID1+jg1mpWvL2HbnLFPp3+6fklvQsu880k73fpMV+13zfwmxN19uNtXdPt9yaaL29al WV+BKRKceB/jSwvXWvzDwKsJpxcVmF3Cj8/Ru7hM1oWcyLLMMRrzMgOPQzhKbXrKzfPOnSrbuX0r 1DnRRb4T6zOYwiVrCNqLsxplprqnVvO6+gNNUm7PeYVauxRWamj1bWZ4/dgycX0N60swVQRpM9dJ WZ4Spn+3Mld/Oui2BpK2mfoUg9R+TrDpn2mPoJ8cIwvTZEJgxxEB/3l3twHz6alPW4ZQ8JgOnBJN RcV1Ttg4mWLr+LiDbPCrKvphGoDPMsNlkojcNFNxx6Kb3neJwH/J03P8jTFOQwAAAABJRU5ErkJg gk== , the probability of the high state is increased by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADIAAAAQCAIAAADbObvbAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAQdJREFUSEvtlbsRgzAMhnFmyaViAjMBHRukMxNkD7tkhVSpYJFciti7EEuG 42Hwg3NBEVU6n6z/03/CkL7vs/PF5XxIQOTB6mpC6k7X2UnaeVb9vW5R/iiRwE7Sgi36u7HU953f rlreTtIyrfu7seQnr9ArO/FgKVGQQqhQeKu//hJ1tMw0oFxCzlo4lJziwUZibm3F0AnvbUSgUDYw mTaSM8aogYqMUc91GWrChDSWLh5nA38OQIFcwLUIoWxFtWe+17vBLQfdksotNFv5rr4/Yb+UEPBS RUbZIHn1Ihj42O1EiNC07npQHPmwYXNHpzWaTmfr5xMi/39ixFp4fz4RvRKWnhTrB/sPq1bbG1o2 AAAAAElFTkSuQmCC , and the probability of the low state is increased by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADIAAAAQCAIAAADbObvbAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAT5JREFUSEvNVjESgjAQPHiLWji+AF+gla+IpTb+wM4GSn2ClY34An2BQ2Hy l3h3AXQMQgI6wxXMDbm73WyWDIHWGvoXYf8oEaM6WpdlECwvWGQnv92MPf+NFi1yTBOVw0bxZsap nXQg5gBU0MLSOaRoNC1jWO9II/W4T0aDyqQbp2ag/BBVsj2IdG+UQW3GQ3zKbLLgN3byQQv39FK4 lrIjEAAJpFMBgqWizKQyjvDoZFXChR9B5ea0seV7OAHR5ZBzwXE8OWdXN7p2raBXPQdZuQERLRxV bNL0tSb1aiTVrUnuQGR5md2MtwGG4+iWyQ6OBpVM6Ws+LbS+rszQMjyA2E5vYrVVi+RpMJcHEPAR CmEM29Jb5XfSZDtnIECxfuOmRkP6AIXlpdnFUC69XkDh+Qh8ef47lBdQ0M8fmydcw3GA27NhFQAA AABJRU5ErkJggk== , such that data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAKQAAAAQCAIAAAAXjEN1AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA4RJREFUWEftWD1y8jAQlb+zmBQeTkBOQGhcpaUzJTRfR5mOBsrQ0VLRBJ8g PgHjAvsuzq7+LFuyJdvATCZsJYR+9r1dvZXsFUVBnvY3GPj3N2A+USIDbcGOF563iGGQ3qiQl+9e vdddfndCpRs338kJ6aNgMnR3AQsyzu0ccRIn24x2nSPe0htyUradEDEeZ9AlonO5Kg4gypDyH2uL r1YuT33qt1b7ZlakRpjMMQawCtoKjQ2w0TUUrHBNUEaUSLMY4QjagobsqTUEGBhSCQXMiaJI6RsQ au5KdX3WqfU5kts0zIbUAFNNcclYZzesdA0Bi6kkAsnCzWQ8333so/PnVBztYAStLB2HtEdv8HH5 15G8z3xFVbOUBEH5O96k7xCb6phOIqzP9WfvZLXB6nIzsyA1wUwUx7I0iRhTXc1KlwksCLxL0YxP +8n2P7rlL9dRcvzKec0u3Y0Xo9V4vfRp/C9XKMR6Q0ACEpLxixrr/EqC2cs4STNWdj6CkNTHuBOi r0/nAgET6ll3w0KIhmRBm15IrEhNMC+kBI6s0tPR2RzoMoCdfhYHMpc4GnbNr5fKPzQmvHbAMaeS q5Zbmypp8sXkkEsPSBRIx5CyA3ON7vSUTZQ1UWax2LhCNcGsMtyzrDjR1Qq25b5Qmcd/oIxDEqAo +cvv4kzeXCSiIZukHIL07+ZpuPQx62siLk4XO2PS9G1dT4zjglTWDqBZaJc9Wcuq1fVEgg4q4YUc qsob1bQaulJQlM2c6Gp1DkOGFp6YWtWsrn8YbHBeuDsKJlyDuzKAEE8XlDMfdHz1liKZqCV1JkCF TPbNwyD35SlIf8Orh0muMFU33RZU0g5rMKtmvayawPBLL9hOLrnRBS62FAl8DoKdwqKoEQhRKNFh ekJoINjKCYo3K9rrZrV6AuuwwELGsKsBVjv35WqbKikIbvG7Io28dlVwc5ePihfzI0ugndstrwaz msCu8qO76EZXA1ghHXNywJNjEqlpGCXsIou3LqavtMRCBePeuBYydjiVwqC/GQc8QOXjVZ5k/vQf 8PQSnxEAIW12KLQ6TH6ZMH0JsN10mp7YRrpMTy/5pLLuJL+c8KiS8tOJda5pQM/LUq+9eHp1iFLv beoTHw1TnqWbgiXyg0J/Ysprbv81XGY+ap8GXx67/T1280DEyUG7HXWqgs/Bv4QBD9L4l7j6dHMo Az/9vL0TpTz3DwAAAABJRU5ErkJggk== . Hence, substituting Project III for Project I generates a social loss of $9. 43Substituting Project III for Project I increases the shareholders’ expected payoff by a positive amount data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAI8AAAAQCAIAAACgMbtSAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAy9JREFUWEftWL1y4kAMXu5ZTAoPT+A8wYWGipbOlNCkS0lHA+XR0aa65vAT hCdgXGC/C5H2/8fYWvtmyEyy1bLelT6tpE9aRrfbjf2Mx99AsRy9HAIY+en257dZHf146/GeIiP4 1b4TPD5aFrAnnJiD9f559LyvyTqHbdRIhonxT5MshUOPNRZyq2Wc8mxX4fdwIk5Vu4zJLXwXvwSx gJ9wQDbHDinHPimkaTSW0ljhfL/UoCU2GKhN1goajb0LMg6XBmTdoJAAX9QNs1aZAE+ACSfKV8ZV ofPQuh6+4vryPM+MbMdXUpGrOeZu8Ga0XWLWZanY4hvbATIGEw9ueVncWkuX1tzOhFU5mfEiF05w tf73zubTxCKVqjxnZgV+5eJ87KhKlqbmULEt53BXlq5kOmfrLXJ09Kj3m0N+0sU7S8eNBmqTpYIm YztAxkITUBhLVsdddi4rdV4bK72FrI0Dyw/MeakCit4cLleoR+GEywH858mT7az6emFmpfh7UPoj cddXlk6fJhJwsdykM+bpAgsyDi56mBgqluP15G2VdFp6x9hOkBHYwsu0rNPGSg5XpQZzm0peAdGp SqVB9iQrQUsy/4EUoQxa5C35pS/NCkkcKtVQxfHOfhJIOhcCLEu8b5z8DbmFKbA7QoThuBzYm93h R0QH8uXZ8g/odzMPZKkcFpmsh9dRWiRU7RflbJUgRpdzG4CRhEP6o6Rk9XE7sZcBrSwVJAkVd4Lk QZnIjbRkR21QR9tDww8AN/7dYKEHmek/eZukeoAgESLBKgAWrKjsDI0VgdkOkmq2a4zpgtR5+d3q Morl4l2Uqz2tenul438VLQgzkZPjFJqwV+hSkNP9UAt5nkQDVgwX23Ug9b4Mz1gaSBIk3ASspHiI /6lhdUFOh2CeHhDFPFAiio0VcOq9IMjXeXhRA0y9LhCfx+HeUkM7TVOCMQqVWd5iTN0S70d5InwP Dnhc6ofpXVQ689rfW91XEMUm3eKIO3qyoPXIJypytz3c2KHeUokUkZC9Lsocwrjuq02/gftjGKI+ Xqun7Vv9qwv/8S3Y8UO2v+Si8nU2fitvfZ1r74nkE/xoQjGGTBCgAAAAAElFTkSuQmCC and decreases the debtholders’ expected payoff by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAANsAAAAQCAIAAAAQzp1gAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA/9JREFUaEPtWj124jAQlvcsJgWPEzgnSGioaOlMCc12KdPRQBk62lRpFp8g nIDnAvsu7Mj68UiyLcmIJbxFlaJIo/lmRjPfOCHnkGOfkoaR7kPe8ZB1txZwCo8I4DVF0WPtYYHb WOBXx7XZPIrmGWwwJ8qpcvMcPW/KKwKQClzjDieY18eIoV0JrxNS0OO2YOsSIHNqsi6q1X3KZ+ZE nirWCRH76Qls13rdt85wOYoAWOsvsEsBK8xGjEwX+is6ehATjhGfZNKk0S/FG86hrUr6ObY9PJBz CZdJN7N7qVmqGUzkijYRisAWNUrkYe6svjGkBgG/zrjNzx4tu20wGzHWuBBiT3WKdZqmyH5KPHJP 9LUfSw5BHGpR0gt0R3hIM7OqXW7et+n+44VnuGQ4gFmRjybVijnh+8o/n2Q6jtVSyg4TEi926+SQ F30LbWJIjsdTslxRGlEPKEQXEgYLTBNjkR+QbvBTyszkO4qcDIcIySqfwgNHqJvwOl4SzKFWJR0V ktvawkOCZRFZmzWbD5ajt0VcBenxBOTQnAjp4KzD6AkHpLlSifAephwW5ONpogl8+TjvyCyiwxaZ lEWJfTCvGLIVZgPG05HUqLOvrbCxJ8ryRIbjpxF/s9n8fTghmj0b8DpeEsyhdiUdNaqMbQQM8qYE ywgjpSxV1fAhRGbBAkFIQP+CpsqpC0OnxE5OR4uYoH60DrniNG4Ut9SPnrNur/IlOBGvVVDAQYrJ lPtaMJRDGaOxKOkOvDs8OFiaI8vTkRaLePF93pNXW6rpeBNqwqAvQskfIkmxVCWHeWG/xEP1p2Py ZeZLKnG9g9RPx3FL3iRD8Xjiopwgcgc2VqsE7HGDKckCVKjNLJ8sYqqjwVR09ZyEB3Ooq5JOWhFL eAioLEWKlOH1KPXNag9QU2v3R8R2Yjmy7zB+Y0rl6ash/aHs49ke6RjVPNaWy+2IRYNftZ+ikTQq lKey4tpQDnVT0g7WdCvuvLQ2GXIkCt1stVTTWmcG0WkOkBeRMODRvOJeySsTYTmrJW+vmnlIJVe8 0BnZUXRd6S+bzz4ZfdyoHVKbghpGyD5BSCTYnJlqMIRu+zd0RkZFaeRdTnYM5VA3JZ1Uopss4SFJ ZpWRgFhxwa78Soa9eNcav/KTg56ZztNQiWzKGI6ZWHwJA7WqqcdXFZQlkRRWWujwEIVyGD2pUW5t Sa0VromIl5gADjW/l3YSdYuC1vCQziX1d3AP0I69Ri+JbYd6VrAAOnhRmQD3NRU5D7Hyi7/HmVs4 FKuHnEtUotYLRN3H9jrucOj6N9iU+LcaXHLbXTgUm1sDG0HNJrtv3oU6c4LHxp9qAfibNPDpO3bo 439/fmpo/a96/QVktpWrZU1W8wAAAABJRU5ErkJggk== . This obviously makes Project III a bad project for Bank Alpha and society as a whole. Yet, the expected payoff to the shareholders with Project III is higher than with Project I: 55%[$180 – $100] = $44 > $18 Thus, regardless of the social loss produced by the undertaking of Project III, the shareholders will always prefer to substitute Project III for Project I, if Project III materializes. 44This result can be generalized by observing that the shareholders will prefer Project III over Project I as long as data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAXkAAAAQCAIAAAB87ZhMAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABYNJREFUeF7dWz164jAQFXsWh4KPE5AThDRUtHSmJM12KdPRQBk62q1oFk6Q nICPInAXViNZtmTJ9nhkW17cxHFkzc8bjd6MFXaX13UzmWyu6X282cTq12REFz90LdqXd4yZ44qP 3pJzZvBfA/nT25KKCbrFK1WmHeC6hukxrJCgoGxh6dg01SS5J0SuEUo3sNjbXmPl83MbTGeKXB7G n2174hHw0nz0GDD11IpfYmc/HXbx+ypybfNNPjstB4PlCeRZN0rMyyzeHWCIdd22z4Pn7a1JfZxz pbpRJfXHmVQL1Hv/BV6pkd7Albqrq/DTV4cvfrn3OzRBSs4jkjAgYyPmbFKMtXZnz13yGCcz2jfp zCDbYjbwMFMmIWzygdKVwIZM4qcb62ImWNsd77biT4wzsTrniLByBUYEHi8dIekRany1A1waSg5S 2m34yaKE6B13sDlXUMeIQA3lDJfKMqH+4oaCWDRD7BuDxmado7R/lC/wdOwJ6ifitDcFQpqU8k5E SeVA16ZeYsA5Ez8nrN8UHXmHE2F7ynrCOX0ca6j6ZRozYusBh/dHNtJhTuvhJ20syja1C9d+IAI1 1PXyPRk9NUzYHNNdL+PZCzy3b8zR35er9uD29w+bv+oFHiicPeG/xXJewqUMj1b7zUSTG73O2dva WcyVS+mdM1FOuW0/dvHxU3lReqVBvNholOlxWl/mfCGZmKLU1AbVAY5zeXr1HST8uKHkCLQ96TIh ACI819x+zmw8bLJZA3UaXAAwvxctGgbhfP7h/Rb7xvBONBwzMS65uKO+TfVMhXl7hJgp7Zk1uRzq ia4Gci30zJlIrWG7SfL1afn0NobeXZN4sdHrcJxk8tPyYzRjeUyxiopxdYF7+bzv2SINSU9ZnYSf TDaUCHSmGmsFhUBE9oabvHhymZ5lK2V+WS8/WLJdRquv+xf0n+2beuIh0thuKtPZYDDdUXdImxDl Uq7Jr+pp2czo1p0p1ZT5GnqHg8Psfhf8pkm82DB6GomFc9seRvsV82PSBODAGrhUzpH7H+XqLvy4 du1EIPCcAIg4co1axMlPDQ/FV2CBa6vd4KcQtpt98k3rvGPvKTGnAOt6B6qU7OwPr10tUpbpadiS 49EmIYIQquBHGPMdChf4E6OkvzMxUoDZQr6G9XhkU3q54UY4LcV4VbZdXGarCMyyKyiUqllmVMIQ wGl6qZwzO0janV3FYW+a1e/wQ1kRChFSa7j4GIzWP6ce9Mq14PPNVvPPtdtk+gcvM2XlPn+VqV8s tdHWcAPORDVDNXMI+lfiJd0sPh6pnrPPISoTmKynrUwtj7vkMw36y0ao8CvrDtcMetuEMIgkvIbQ maigKafl4g8MuW23ZLoqROTK1qaqZWhRKEIElYreGhV6W20iNC/rsTOdNmgE77R+q2J3VW7I4cUn l27mRdRk85tXZ/WIiC2OBpxiTQu2h6SEZtuBws8vAk2n9QYR2rf84syqzj7wjUPc1j4lYO+s2hNt drVVEkRkp3ISUOxdjvzNm34wwkFBvJ2JoTVgKv8kXeiKijkweGn+TXgFldio12sBZ3MfjF80nqS0 7Sz8mv/mnTMhBCJdnq/BAew+4e844IebjjSqqvzrwfkakl3Ol9ITe7Qp+4BXQWFMM8h+i1BY+oou jcCaNRToEsAE6QLNEPH/UMEUcSBS6GTYU2qTJALkvnL65EyM+VxfdPOij3ilOvkCV+6sdmc3ZLcl qq15Cx2XEyj/99JutwmO6hODmDCvE7rE+QK8ZmVLxbxD+LPS/ioKVzGB5+uV6nU4oNcwof3QYytk bzhavY+zU7L86BNcqdZV3cAG/26fcGxw8o6mMp3JhQb0Z7XJ/COwOPVEux4BL2V5r2FCw9NjK/4B e/LODrSJgF8AAAAASUVORK5CYIJ= , which entails data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAALAAAAAQCAIAAAA5yWLnAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABAtJREFUaEPVWTty2zAQhXMWWoVGJ2BOILlR5dYdVNJNOpXu3FClNZNCbSo1 IU9gnUDDwtRdlF18SPxEfEh7YhQeil4s3ls87AIguWKrKHE0WrF/xrUJXVkDt2Wel618Db8QNC3L nP7GZ/wfeymM1GfRqSr7/lcwpvizotChMx72oEOIC02EtTXMMFkHU2SnRit0cBJq+B/YgdZ6PYjJ 5LMZAE4TKu8CEaMVxjLMg9QUJUkrJQBjZ6IxZUiZcoPJjoD6jQQBUepngk1mQojUDCG1FKqpEWGO UQNL2JrmEsnajgJg/GClot7cKe3n7uKqIGHvBl3Vu3TX9XGfz+8liGy22K8A88uZPN+nAb58nNHb ZfdCtkUWxg6t7uf5/lhb9oL4RvnPZfcTIEaj05nCQMlkXVAFTo6KI7y7U1Bz0WDiFKJ01qMAaaml 3elKJO2o/NyPqyCMADNgissOth9x9UIGy0UC8jqlStnmZT+e7pRMXfsIvUiao/EMgU0uv6w4lPmp abUlALKKEPoNV+sK9nTVdha+GBXLtjkpCSLJhd6pbcj8oXi/vsdkB+nCjA++R4fzfoz6tXmEbd3j Q0TyYb0nZmpBRf89KvhF18seNhfE5e+f02KmIj9/aGVj+XY9kCeWXTzCuO1qCa0o4I8WIb3EdIXL HAXzu45wrCaWb0lS4BmcGPHBGH6AwGYLEf968zJfEzOqIZgnZeqAqvu3yhMXhCkT4gh+BqsJmxSG Wiz1lawpzuVKjQtIzdVSJysk5J9iAwuBzDIo2iiVy+44PxRk6qQ2BXBcsIRtv1hb7Y0cxgShywS7 DGRnKYz10ZUtolyNIKhugr/m2QO2bRYy87a7p2ZdZBgKo2AEpkNtqFh2XpwnZVsD+zoj76IgIIko yOvX5xMd2naLnelxfbXrb6QrFKN2wLlZMkya02wsY7wMB7o+nvEIBCn69Lxqtm9LjKqVZ1PSYQxG tPXhVFUKmjXSOUFBQMGQMoHpWe1pBXzsJqfuiRxwYKdNoCvFeUSM7Lo9IsVM2xUiy0MINSMvf0H4 PHl2ePhPYzq4gcAJ3hBxJyoB3riEwyOj934uzFWs4vvroPgTnDYWO/Yiie6BXWyJlxGwrHOhOFAr AZKh8MbMMax5TWmZOPG7iehQ5W0tR2VdA7BJ/jY3leNP5/K+j19ZizCrz6Ga8M5YqCO3nZepE7+b SDzU/h5i2hw6ubfs4dF5QegZiNU5fobFewJ209k9GM+BmPV9UmCnCDM3UxeRW6S6wRKgfhtBEIxT ZG2F7S9ufa/b5rXGoxQv892D8Rw4Z3i+jL9tCnTOzGymbiIqfpVUr4cUqOPS29f2Nj/6eEZP+Lrt 55P2UdnvV7fQmTqJQIfuK4P7c0MS1H9BbyBdn2IUkwAAAABJRU5ErkJggk== Figure 3 below summarizes the essential data of the excessive-risk-taking example.

Fig. 3 Excessive Risk-taking

For simplicity, the examples above have assumed that shareholders exercise direct control over the corporate decision-making process. In reality, however, most large U.S. banks are organized as centralized management corporations, 45 See Luc Laeven & Ross Levine, Bank Governance, Regulation and Risk Taking, 93 J. Fin. Econ. 259, 263 (2009) (providing a cross-country analysis of bank ownership structures and finding that all the U.S. banks in their representative sample are widely held). where managers rather than shareholders make corporate decisions. The next section develops the analysis of the problem of bank risk taking with a discussion of bank managers’ risk incentives.

2. Risk Preferences of Bank Managers

Unlike diversified investors, managers make specific investments in their corporations, which they are unlikely to recoup in case of failure. 46Michael C. Jensen, A Theory of the Firm: Governance, Residual Claims, and Organizational Forms 144 (2000). This explains why corporate finance scholarship has generally described managers as more risk averse than shareholders. 47 See, e.g., Henry T. C. Hu & Jay Lawrence Westbrook, Abolition of the Corporate Duty to Creditors, 107 Colum. L. Rev. 1321, 1351 (2007) (“Managers of healthy companies generally prefer taking less risk than they would if they were acting in the interests of their presumptively diversified shareholders. A shareholder has shares in many companies; a manager has only one job.” (footnote omitted)). Consistent with this view, discussions of the problem of risk taking have long been limited to a subset of the central agency problem: the conflict between shareholders and managers. The concern is that managers may pursue their own interest at the shareholders’ expense—in the jargon of economists, exert insufficient effort. 48In economics, the term effort is broadly used to refer to any action the agent takes to advance the principal’s interest. See, e.g., John Roberts, The Modern Firm: Organizational Design for Performance and Growth 126–27 (2004). Conversely, insufficient effort defines any action of the agent that does not advance the principal’s interest. Managers may shirk by avoiding actions that involve personal costs. 49Shirking commonly takes place when managers are not fully focused on maximizing corporate profits, as when they exert suboptimal effort in running the business enterprise. The concept of shirking, however, refers “not so much to the numbers of hours spent in the office . . . but rather to the allocation of work time to various tasks.” See Jean Tirole, The Theory of Corporate Finance 16 (2006). For example, managers may find it unpleasant to cut costs by reallocating workers, may not spend enough time supervising their subordinates, or may overcommit themselves to tasks unrelated to the management of the corporation. Id. They may engage in the extraction of private benefits. 50Managers extract private benefits when they exploit delegated authority to obtain benefits to the detriment of shareholders, such as when they divert corporate opportunities, spend corporate money to purchase private jets, recruit top officers from among family and friends, and so forth. See id. at 27. And, finally, in order to protect their non-diversified investment in the corporation, they may select projects that are too conservative from the shareholders’ perspective. 51 See, e.g., David I. Walker, The Challenge of Improving the Long-Term Focus of Executive Pay, 51 B.C. L. Rev. 435, 446 (2010) (arguing that, as it concerns the problem of risk, the focus “has generally been on the problem of excessive conservatism on the part of risk-averse executives”); Rebecca S. Demsetz et al., Agency Problems and Risk Taking at Banks 1–2 (Fed. Reserve Bank of N.Y., Research Paper No. 9709, 1997), available at http://www.newyorkfed.org/research/staff_reports/research_papers/9709.pdf (“[T]he owner/manager agency problem is characterized by excessively safe behavior on the part of the manager, who pursues his own objectives at the expense of better diversified shareholders.”). Indeed, conservative projects that reduce the variance of the outcome distribution produce the opposite effects of increased risk taking, expropriating wealth from shareholders to the benefit of fixed claimants, including wage-compensated managers. See Jensen & Meckling, supra note 7, at 353.

Stock, stock options, and performance-based bonuses, which tie managers’ financial rewards to equity value through compensation, have traditionally been emphasized as the solution to align manager and shareholder interests. 52 See, e.g., Sanjai Bhagat & Roberta Romano, Essay, Reforming Executive Compensation: Focusing and Committing to the Long-Term, 26 Yale J. on Reg. 359, 361 (2009) (“Until the spate of accounting scandals that began with Enron, compensation in the form of stock and stock options was often emphasized as a key to improved corporate performance . . . .”); Joshua A. Kreinberg, Note, Reaching Beyond Performance Compensation in Attempts to Own the Corporate Executive, 45 Duke L.J. 138, 140–41 (1995) (stating the traditionally dominant view that “performance pay represents the sole acceptable solution” to the problem of managerial effort). This is because compensating managers with contingent equity rights makes them sensitive to increased equity returns, incentivizing them to exert optimal effort. Notably, U.S. corporate practice has adhered in full to this compensation paradigm, especially in the banking sector. 53Executive bonuses in the range of millions of dollars, and even tens of millions of dollars, were common practice in the banking sector before the crisis. See Johnson & Kwak, supra note 1, at 61. In 2009, for example, it emerged that Citigroup owed a single executive a $100 million bonus. Id. Along the same line, in 2000 the average stock option award to CEOs at twenty-seven major U.S. banks was $11.9 million, compared to $4.5 million for CEOs in non-banking corporations. See Mark Watson et al., Moody’s Investors Serv., Don’t Bank on Strong Governance: Observations on Corporate Governance in U.S. Banks 2 (2005), available at http://www.moodys.com/sites/products/AboutMoodysRatingsAttachments/2003700000425158.pdf. In investment banking, this phenomenon was even more pronounced, with “top executive salaries averaging only 2% of annual total [executive] compensation across the whole peer group in recent years.” See Nestor Advisors, Governance in Crisis: A Comparative Case Study of Six U.S. Investment Banks 18 (2009) [hereinafter Nestor Report]. From the debtholders’ perspective, however, equity-based compensation produces a negative externality, which is amplified in highly leveraged corporations, e.g., banks. Introducing convexity in the managers’ payoff schedules, equity-based compensation transforms them into agents who prefer riskier projects over safer projects. 54 See Richard A. DeFusco et al., The Effect of Executive Stock Option Plans on Stockholders and Bondholders, 45 J. Fin. 617, 618 (1990) (“The asymmetric payoffs of call options make it more attractive for managers to undertake risky projects.”).

To see this, consider again the example made above to illustrate the problem of excessive risk taking. In this case, assume that Bank Alpha’s shareholders have hired a manager to run the corporate affairs. The manager’s natural risk aversion (arising from her specific investment in Bank Alpha) is represented through a concave utility function—meaning that her marginal utility of wealth is decreasing. 55Under utility theory—which studies how agents make decisions based on the amount of risk they are willing to take to maximize their monetary income—a simple way to represent risk aversion is to assume that the agent’s marginal utility of wealth is decreasing. That is, risk aversion can be represented through a concave utility function. See Roger B. Myerson, Probability Models for Economic Decisions 83 (2005). Specifically, suppose that the utility function of the manager takes the form data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACEAAAAhCAIAAADYhlU4AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAZRJREFUSEvtlc+VgjAQxoO1IAcfFcQK9u1lT5aAR5uwAL1agqe9CBVIBTwP Qi+YiQmQzBDmsc89kWMM85t/32fUtq348Fl9OD6EXxj8Ji+9WnrF7wD/5X/slVB+NXnqk+RnjV9y 6mhuV3GqJzMZfaAZzXkbmbM9N34igNh9x/MrsXVInWieldebD6kfZZqQCJ3bvnDpxT6KvEyHFaq+ Z7lfcp4JfNm2MKN3YsTRA+y+sjO3Y0XhSEQQ8GYOnmhGlz/84FLUDc5Wccna3Io6imXYnnoBKYTb iMC6WciEPvIMVcFGdP0K66P4vaCVUmsm5GbNWeU4SUX5qIMMhch+vjjRjMQIdYnqGWI0zwoj1KUQ I3oZySbAAH3jnkD9KjdfqPHhrqZ/P1Ba7RggT0eyf7YQU1WaAAPCR8dKistx4FZjFrLeSBgkZ0rQ V1iPfr9BWb20RizEKJghwV7qQ33ozTd6IK3L5jNH5/bbHkJaSF/yDL9C/ZpAeJ6H7YT2XbcUSRjh pIWbB9BI14CwX+nRs2bK/fd9AVRaUmMC2n9VAAAAAElFTkSuQmCC . This means that when the manager’s payoff is, for example, data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABMAAAAhCAIAAAC0gAc9AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAQhJREFUSEvtVcERgyAQxNSiPhwrIBXYiD7TinmaXzrISztIBU4eai/k4IAD MXGGT2Yy8mGOZWF3OcdECMGiximKJUkHcy+6I6H/TWi5npNm2PNn8PhOYPBly9HX3l11r9dhmlvu YgaSTAXxdpYzrKtS48iic/ACVQPT7tRMJQA3mzNJAIqT6KbPqhNd9SUpXmSAkhFe10qtN9QV4MSN A/eECa25fnqEGqZ1pUQS7jvFwFDCiqkTNtwwIQo7TCi93OHk20M20/x6MlbmKaWV5qUugDk0Gz2H 8WUFqBunhZjLNIJcna19IVAiLcjapOkas63m+Fy1Hj1C2JiEhQn57/m5iv9Wkh/8Bd9QyohteV0E ogAAAABJRU5ErkJggk== , her utility is equal to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAEoAAAAhCAIAAADxgaq/AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAptJREFUWEftVzF24jAQFXsWnCKPEzgnYLfZatvtTBmadCnp0pAydNumShP7 BHACXorAXbwzsiyNRvLEgP2APKsCW9afP/Pnezwqy1J93/Xj+1JDZgO9a67vUL2hehebgUGcF1ua FoEN1WuRpIvd0qp6++e70QnrjOTb0Nu/v6rlDobTI9e56ZHq3D3veTTI7s+v8RmDPB66rl6qy5Nn m9d3zm/3sZncXCc7pajgdss0y7kC80wFF2FjePFI6R7+2AHodfW0PpP5JtBB8bbKfk+Pl8eZn8Tk 2aqFeYErlW7tgmrSRSuLj5MVKuHwSkW01AThBWaC1uIkYTEujJ3eCFtMGvRfQ6I6wzGqwDplKKBr NBu7w/Z6L0xunlG+lo6tsm3MGpqXuUN+Ajp4oiNn6wXY8nsPGk82zelL+SI1Znqb9Nh8Dh1+re+d u49vJgZWaofANI2K0ywLndPXB+azY23WPRRF92lYcEmc0fdEFbde0ZeILZYkS2ZPQYGZA0SNrfl8 YgkCvdA0LYzzIgfid1+1oznMUzw0hu7Ow7sW19LDhHoJEdihTIx/1g+F1sKt9BRC/rMhup93QgOt pZjB58Bim6rVgkycX89i4/t/kKnVWwFnwG6lPBty7R2ai0YUVmTyDQ6h6OZmMUvmk5yaHdID2ynL 9foxU5v5E8aKKzatQFSz+r6Fq8wxuQUxbj/JvLr/3II6486pEYVFXdACCei4B+aun9vlzhp5McMk ERAqsKitWEMywsX/tcx5szEj7UCaErp2Va/TqzchH6lNvE2NxyxPmtd6sJVm9KgVc3r4RaQNX7IV M8X1EH3bCn8VHTmHTS3TBzSLxd/r/YBlFhSkrIdZuG1Zut83giMZYbCg5ONRniV7HCQ7Pfo/9G49 8oJu00cAAAAASUVORK5CYIJ= . 56The risk aversion of Bank Alpha’s manager can be generalized by considering a utility function data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABUAAAAQCAIAAAB2uKNyAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAPFJREFUOE/Fk70RgzAMhWVmIRQ5JoAJfGmoMgIski4NLmEEKprABkzAUYB3 cWQ7mPBjuBxFVBnbn6SnZ4gQAk6Ec4KV6BHPWUhCxqcqdUJIUk/f2L8thjSAIB3Wx1Vs9mGP3oQV gKn1oZU3N7YLyN7iSgjULxUZjahXyeWvovE91zpd93YP2p6DUydlJJPp2MGWgwNougEcmmV06MZa uIoj+oOn0r+6zDXE2SMPrpdtnGZCZLPU8iryvG8VxNmzAPA9YAnjoz5bK0YojhftlIGGqNXHtXHC m/M/9k+brDxaxZe39vejKdnR7BktNsif/7830YyMTNJm7w8AAAAASUVORK5CYIJ= , where data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADAAAAAQCAIAAADfzGvmAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAYJJREFUSEvNVT2WgjAQDpwFLXyeAE/A24Zq2+1C6SU8AJTY2W5Fs3ACPYHP QrhLnAz5hURgn7vPaYzJzOSbme8LAWOMvJOF7wSGY1kIqCt2wa7oRBVNFgRZ8+KSYGQea/M4zlt9 CP+JtYFHNXVs+pOOTnhWNJGa+GNral4/hGcBHeOcCQnKIbQGZ1WtH1BN0VOYH0+fzPSd3zezvWIN HOJMUMQAkgiOJGWZKHp0P9+X7Tpy0yX6+Iyvd0ks9ElKdiJfkFdndsR296u1e7m1JGyyKlVzJE8v 1sFjNvNctkX7M3ZXAvOwX5W52iCZQt6I9ibLhxVNdWNeISAJLK2c3Rq0FmXfVMceRVccjvFmNQ0D JsKMgXKN+MP4UwFWpYyd99bUo/VW3wW9wCTISVRJm9OYsxN+TbX3rF5IavEgmHp26s6tMr7bPwS4 cmvYIaUnAlQXTcpfXC7UD9+xyQhT+UN1T7Rufm7tuQCQHIPuIK/u12+iB20A+9Mk/kePhR/Xv0f2 APLBzsYgV0bzAAAAAElFTkSuQmCC and data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADMAAAAQCAIAAAA0+9DlAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAXFJREFUSEvNlc2VgjAQxxNqUQ8+K8AKuFFFOG4TWwAcsYQ9cVmoYK3A52FD L9lMMiYI+Vqe+pyLkfwz88swM1AhBHlLy96SCqDWko3NkR6bEe81VJRWw4MvKd+mx3id5zWXm2aB Qvmf6J2p9czx0O99sQNelaFr4j/bM9SYhdLOOa0D/04cUN6LsF6712x+sp4ppRBmEQHTXvFQgMWV 8mnCcS3JANe8iNi9w8HDp1UgG2oCfweL6cuGqivNKybj99f5sNsk1/Ky9M9XPj8NIrCuVDA/H07/ Jux2rwouK9q24NcbjlyxskgGiwuBColEG3R8+b11uvYKU2PoThpnbD5P+X4bj2cURStmAWfnQVB2 KmWBsbLZHWxQmR3lxDYbr1kOFSx/FyMhrQHDRYhl5u4Rd2/ayrxrBv+Y8zRgrHvQIQRZjkPdiGDY 3YF5FhrBDrZErvhoQ8UaMj3kphf3pCGZwiWk8uE/Kv6F0rVf9Ocj/gHc4mj2LgGbOQAAAABJRU5E rkJggk== . Finally, suppose that Bank Alpha’s manager is compensated through an equity-based scheme to induce her to exert optimal effort.

Under these assumptions, consider how the risk preferences of the manager change depending on the level of convexity introduced into her payoff schedule through equity-based compensation. Suppose first that the manager is compensated with a data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACcAAAAhCAIAAADVmCV/AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAaNJREFUWEftVz12gzAMFj0LyZCXE5ATkCk36GZGsnTLmK0LjGHrDTLBCcoJ 8jIE7uJaNv6H0r6kWWotAcn+ZH/6pEciSik83V6enhEThqx/TXtgODD8OAaCmh7H5ThSYPg/MNyX m2hT9v5VMSAta6y4DjkBgCaLIs/JN7NvCW41GbCSopO+4bcrEoDBzZ+B1OY28YYA1l506IUWJs8q 4ya8XuXA8eNJNBPZzoJYEzkp5Z2Tnig9pRMSas4VwHoZy3C6Y2mrs6I5WS1EaLFK4HIT5enL1z0U b1OYs/3a3y6MOYmsTibhAdprJ7zdtR1OJ3J+5Oqk7oVms/oM4J2k4fNwb+SE7PB2zfu+JYfpnHd/ rcX5Z02qLcp7W5Eay9Rk8kmr2+sLU1tjavJ9lpwcuVMtIi0uT91CTd9ZvFwbtZMr/UK7ItKEA+pP VZ+vm83KpWlq1tW0cWRW0FERmer+YdY4P2CrHMXI6stjxYbBWE/wgk6KyOg9BsMLIyaObVaLq8nl zB97lnhb9NSyB4aaiK4sfvfuC8Ycst6QisJ/url+ujP+BRm8KEj0IUFIAAAAAElFTkSuQmCC equity stake. 57The equity share of Bank Alpha’s manager can be generalized by posing that the manager is paid with data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADAAAAAQCAIAAADfzGvmAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAXNJREFUSEvtlT12gzAMx23OQjLwOIFzgrR7125kTA+QMVuWeEy2rp26FE5Q TsBjCL4LkY2/MYHyGDJUG/6QfrL+ErhtW/RMFj0TDGdZFIjRDd5Q9uccix3Gu0Jeg5ItYs2ZIHJu pC/+JcwsuVHyDKEst9ZgQZxFi9C0AGCF1tFcyi5Ux0oIcYHEBviYBMQDGAsk3ePRZ1Tift4cy3kh iZpFiBdelzCgAijwMVGl4H5/97GnEvbzVaZrtcpulbNf1s00VcWvb6SK6Al9Am5141osTh9p7gYs vq/ZoYcwFkHjrRIpprEbcr+M9hcdjdEjyi/b3tXrCzyhsSl91OU3x0Tbx+sUoYa+14cAjtcNoZK5 gYU3ZU1dkmQ1nYx0os4zUL2vManDIVnaMnVFDe5kFlaXwZodYFDUAii0a8XTQ2V4tPgedF8qCOuA 685Qmrb38ps3mR4nBSXQQzPsX0HAC/WG5jwiUfnh0fzIqX0P///tRzruDvBUn6tMM3gXAAAAAElF TkSuQmCC stocks. In this case, the manager will always choose Project I over Project III. This is so because, given the manager’s concave utility function, the level of convexity that a equity stake introduces in her payoff schedule is not enough to make Project III profitable for her: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAb4AAAAhCAIAAAApqFmcAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAACDRJREFUeF7tXT1a4zwQNpwlbMHDCcIJgGYr2nRJSZqvo0xHAyXpaLfaZpMT rE+Qh2KTu+TTSLKsf2tkmzhmUrHRj9959Wokj0bZi+PxWNCHGCAGiAFiAMPAJaYy1SUGiAFigBgA Bsh1kg6IAWKAGEAzQK4TTRk1IAaIAWKAXCdpgBggBogBNAPkOtGUUQNigBggBsh1kgaIAWKAGEAz QK4TTRk1IAaIAWLgVK5zu7hQn9u3Aw3E+BkY0ZCPyJTx664bC90hP5Xr5PbMNywh/3j8+zTpxjzq ZcgM3L3z0T5u5kNGmY6N1JvO1fnXdNV7Utd5/oSSBcQAMfA9GSDX+T3HnawmBoiBVgyck+s8vN3W AVL666wYaCXSUTQm9Z6VYA2wXgGekes8/PlVvO5FvIw+Z8bAKLxfGyNIvWemWB3u4F2nti57Dt1B e48PdKDUZv5S2/4YIPX2x+0gex7YrnPKt5Wbefnrj52wtP8sb36c1nPy2bHY1gMJX+j/HuQQK1Bf hxYyOb5hyhmpt8cJMDj1Dsl1Tp7+8jylw7/d/NlOWNr+Xs9/3vU4NA1dw8jNio/j8f2EIE5nPu7J kMnxUczMdQbXRYvah7dFJFM4Xpr/WFJvPnfDapmqXvlKv3+d1vhlxpr2tq8XW6V1kdMMMvjcvurk vvBzfF35eoKHi7Xe+nQL2PcYKz3Rb4sPm9HQqhCB3S5UlI32GIcULfWPDkDxjlmmhYZ0hYi17uOl mnWkXoP/0Myy+LRZ60fAg1RvwfgS5ioSOE6dEl4u1WjV5fnNoq4zIyKOU+ZFu05YfAMPMcvYN/Zs U3S607BrwI4l1QMkUP5PHXAQGy9QgEU11TAGO9Ot8GbZaOumqptkYQjAoTXH6zoZHTku1WHfcQGh 9ZvUC8ykq9c3+XXh9yLgwaqXuU7HVVpe0PKJRnXdqZgOxnV/hqLdh1Yu3N42yBloTKrqUfpY1d13 DNidmuobZSR7ZOUBo9gs72BoMQa7tecEdGi09nJoDVoKYI/vjO065ZoTeFXxs5DvOkm9QrWJ6vXM NscZaNPUN8XxOs6fa32r9xIii2wjdH2lxRuurqeFOqhhQcai0A5o7n6yvdL6tzosUU2h1e6fON05 vM2Wxet/uLAgixZV1Fp3M/ef5uE6RCOCMceOAbOT/bJoCrMyQBWeKDZWqJs2+XGjaG+C3WE8KBVt HFIS4MnD49Rz5hcyRlx321+vIK3uKw6aSL1sKFL14B+1isIkPXSg4lS0fav3suDTt/zcB4zyeFao WflIrSk7ApcuVjjOj86upjMS0g/XuwYMZpkrSwH+oFjfX9y+fLaTAh9d4ZYbYWc/KRttHFIiYJBX WF1+o+Qa+vx51bsHVdBIvY0Cmzw9z4tyOVNncNvF/bqoTnQT9dD4FKvCcNXLTtjFNnKlCAHHV0Ys hN1l9YG/5Q4U3IDwAtuXZekekWM5q+u3PVzvHjDMbfY+Uq7XJXOhuelJh7cVo2wT2j7rsPPJYy27 QQsQ4pDCpfVCizFEbEE3N0vuQeMs71bqpplnsxooJfUi1QsjUo0HG5L7gr3uhzNOuhHwYNULyUl3 7yygUAqBss+seITji6R9HrNrM2f7L+BxLbwALEXirzpJuNWrF+QqdZaWhAbMF1MfFyAjEasE+/Hu U2zN99hcJ/3Hr3w32wJUt0WLcXnd1pXv8K+7+4BpfF9SPLK8MXEuxZSs1YyVosWQYdmo1Asz+n5X ZbTs2ZggwypjUq/I69SijOw34B4KJ/qpawZebTRnUv0ak1h/YCdVudCr5Y08e9d3+Vj5wS0iIxKL 7aBoBZjHMyK7JhYXBweK3HsyDQI70Z/bs2BLs2u6/SH3+C/45aFVjPshVcXxUvSwyQZitsXYAvVW Zk+ePtho6NHVeCmpN129/HV0WgfiJNfLF+2SSMRRQNGY1OtJiefnItPqzqM/FGoF/yrCtNOh+v2d RwRSw10wUYwdHPr+5RcD5gsPTFft5KzJS2wXfFUxNpwo2E0PiJWno41DwgBOeoNxQAunWe1yUrfn 8dh9rJTUG9eVuzTqx5wYPeTrd0DqdV0nRCpV7LeKb2l+wT640mhgTb2nQ/rZe5g1PlNWO+aE6rhr AVtG5MTjIZbuAPN0A/MUjSF1X9ADq4ljL9twgjdQnmC7EK+XCNg45eWjjUNKAwwBj1Rq6hWYBy5X 1/yuQ8MvYTPzjDd587giXmoQSept0BUfcOMFzOA6TQ847UL8L3eu9a5eN3/YSSDW87j9mZS8EzOv U/+XJ8cznPRllmgpZ54X1ACabgG7eYMKIiuCRDZvpqIfm5PnqGV6JsLG5sa1QCtyfvXbEE56bbg0 lBPfcV6nDtG53mEY4JZqVJJ6XU9gX1AQof36W5N6mSEeVAtWt6L+cNULt4lkeB3Wg9BtDpmqHKli Ss/wpE6RzohLqHUnwZseLQbR/BgVOwXsGqB173ASw2a1EwbYacTOt3miq1vloq21G4TUwLMnI96/ 0MhZknObyPofO4K3zmyudVZJvRUbTTPL0JI7XM3zDi3moaq3cp1og8wG3p1EbbPr/sK7Tv32n9zV tQTna44D7PMAcsHJmuw9GJTQZX9sBh7upy2260ywoocqODHEF3517ZXruCd14ACTerM006Tejlwn GlvMdapden/aQ+P13sbucXLgATa3+Fo6g/cjh+c6m6mzapB60ZS1bjA49Q7Tdcqle9rXqp05jvHb 0pmdjrFZ1DuO3nWSes9b04nqHdLvdWqhS3Hnq8QermOP75D1efprapIMsu9RVYf0vW/8X0STes9a zYnq/R+mWIIKcN/95wAAAABJRU5ErkJggk== . 58Formally, this condition can be expressed as follows: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAd8AAAAQCAIAAADYq+LaAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABxhJREFUeF7lWz164joUVbIWkoKPFTArCGmo0tKZkjSvmzIdDZTQ0aaiGVjB sAI+ioG98HT1Y0uWZI5kQ0ziZjxEv+ece3V1JbPzcdbPZrNsdjzjD6/D+lE18LarSm4y5nmyTblO rfGlAMIHUKvPevBAsDQ2Pt5Qzn0iVvWmK2qbo8CaawwArDuz1K0Iagc18fhE14hn/w4s1B0iU1KP 8M5cal/hmWMZTCJQd3KMXK5+AiYKG2eqsVjFEhkqzwfirssVhb+9aM+toaYpiivaiWKft3MnFmrH HY++YLTqt+14wDZ/Jx2g3mn+6+HX/ASUrFdkO354GG/LbXQmq7fP0Q26Z6yFmHA0PLA0gMl2vcx+ Q/TXIjUfvPui230ZZsu1Q7u3159BUHuoqUW9Kd1G2BcNts5r+S2U/2oaqdyS04PEFlQWCljsbaTa 2ckedH9QO/bqae8QzQH7l8bYBVb2FgOIKg7NxYuJWVN2jPBQA5Y0THSHZZwjsYKDqk2mYHBf8jZQ MaLlSsmppkQrAzfjuaDbVILaRA3MsyiYw6ORaZL9+7NQiQg5BpnZQB9U505WwXZMaDPusIyawi8Y QvdlMqo6SjWC8qDQyXgwybKsSOGqRSHeN9vyuwgLOl6vJhIqJ+FM+WxxmuC+GOPCklfomK8m2gYJ qgATnSZq66FyGDV4L+Sac67lG9YFxn6Ec26LhRZDjstsHA+7fvfp4r7l9OeTvb2ayQ+qWPzC/5cN Xy424y+gB8A3ALP+7nDUpTqvb+x9au90O889tv933dxKDUxYt1vMcTs9vPHzNhs3HCMYFi8mfAcJ 5aDAyeLDDpQ8HnpSIO6LXcMQQKhTcMxXFS1tiZThXNRtomjBad6OGqin0/xjmW0W2hlIkJpkXzSX 7LW+xEIpuyEdV8g7U8InN1ieQBa2e/q3Z71nw+tSZjnP+eZpZq7znVWsVJHnxxAf72HXbdnwvdw9 98uu+KlrOnBIL4FCXkB42RqYsO7rc0+5l+34oztkZdzAAcfB4sPkZXFesRHnsiDd17czWXCA4WIC VtUrf5fHB2Sygkn3xWqp7MfaKVqakGMRVbpNEm3LqEGFUQRq2/HTe49ONBpl/y4tlA9aasDvnbfj 9VBnFH3aktif5lO24sWk0rbT917guJDEyZYDaYcPD4NlaoToBt32KsCAUArVjVUOAyQSE/bc4SQQ eqf5uruaMGyNdyfQCCydyV+xHdVe2j1nTUKuqhL3poO9PIt4O0zHH0wFUTQUcfDsvlQ0h3F0e9HK 6K20WbyRbpMpa5aa4DBkoCaCvPXwfBYx9DXZvzMLfdQuU/0rcXxZLF64opSEQomIzmSRH97zBU/b ltd7GOlUnmgqaVPeL/A8pd22HXSTz4+OwYuOBktjwTA6qgGIkBaMidq7c9udjw7DSYdmV8pr3AwW gzPtpYfr6jiaqnixEm1dxpmX4ROerZSE9kv2O9/gJjmVloqWwLA2i/G6RcAsQ4ZQY5WxbK0+NZB0 ecBPkifJbdgAyq2FpIGxf2cW+lhK3+eTp+s5IvVHG40KJ0i7S+FfwrZlu528YRNnvrP2PfbNPcWl qsdj9Z1zt+uity46sg5YjI7qAkICQDDZU4qNl9y9DwR2vq3pzWAxuZDpKhHLXLo5GcKK1nf9txDO wmep1YhyvrP/Uk8iisG3ULRkQdIHpesWANNxWgg1VhmT6waogaRbRIBqK5+0LOtKKPv3Y6GhvDMp itwH3wh+Mh7rsvl4fgqdV3x+WL65lAC23U560pn2hzropo2XeZpABLnJPfhAABCFFxDFs+/gsRoT joKcCk9t9IVfio+o9KBjYQkdkuhoZ8RWZLahQLb5U9bteMQ1RlqbY9eXQ3S1UbR8rE0RdFGlLabG O3bDF1CsdTG0qgbg+1io1AzBEbr6Utz2FG/FVeXS1V7vRR7jR32XUVaz7pDit27UHRODHe/X285t tCZv1HkB8d/XATEx5qCT/NC9aRO34nRAgAPA4h1cca2pmpSEL67Cl8AMaRgai1CFM5W2iTZJt4mi TaAmDHVtahAW6QYbv1OqrDpJ+lal72KhhVOJu+8s7uRaiIQuHd7q9qVWgX8cVXdtk+7h+kTXWkwk y+Ulq9a8E2it1V8ja8U3IqgF950Rv4uVyb85wYqXS+HL0Z0JQEax8V+jFPUUVJUxF/0x6eOKSLZC /cDX1SP7c4rbNtMKTNQ+xbebqEVJgnuui26wPs7vjyCoTdQgnOffnCCF3TI4++30WiELNWMqVnxG iW4trhgMpfHkrxXFntmE3tVhn6zLmt8dkwIfG9YUrJoiOYrgn0BQe6hBKI6ir6Zzvh8LNX2z8SX3 JkO9c4XTR1i5RRkKI2qFiGKOEYD8EExCK1EsVk1oINq6b7WVS51cA6L1rEFfQU0qAhH1otm/AwuV ntl0XP8DRA5WLdZ60ZUAAAAASUVORK5CYIJ= , which implies that data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAPgAAAAQCAIAAAC0pCWzAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABQNJREFUaEPdWjt64jAQVvYsDgUfJyAnCGmo0qYzJTTbbZmOBpfQ0aaiWXyC 5QR8FMF3YWf0sCRrjEe2E9hV5c/oMfPPPw+NEZf/eZxXYzFenW+h4j4VxEj3VVluKGI3WG4lOAvY UDjRTdt7Xg2I3IjksaiAWf4RSY1m/wK2PqoO0Rkuit4kg1L4EGvcuvlXjih/4pwFk8PwSS9kKM45 kTOnToV+qM5QpBd47xBbElgXVU10BkRox32qI0/4wDEzMadMRCakNRzBDCWoD4vnvuJaGnclThAt UoOfYd2ATasQQR4S6n4syIG3G7YKCYWqjppx1IkC1qIqic6NJzBPcSB8oIVtsJ51wxK85iM4wnJt Eex1XqVp6tQRbWmubak9Ru7icJ1SgStybVJiFT89wMsVlMDWvTBxtwn1dVY2Amvn/gC3Kn5/iNeX hLo8+e/Op9H0GV+FD82LgxlF9r5J92u5IQbN4SO5c3mWnpe8vIrFMr964Pl0UNtdH6Hi55MYDu2i fHl6hfqZBQ5xlJEhmW9X48PpbKZQKiSDkTh+Fv4u+ezhKau8o1Tq0YKN8HbA9uAgCdukikwtBhtY iyoQHVA6jAYezwFgORBleJ5JWiExpSnChxayorcYVfPZ42L0a57wjgBTjBUlpJiGCUX2VD5+HoWn EfwGM5UacMiTWhQqXnyK4ctgpDmZz96HUxGAw1M23NyhsVXBbvY4dH1BvX9eX7birTRF3cm9WrAB 3qI9tq5R8t2GE4oIjeOALVHFiF4ZQJ/JUVVSr6fl7F3oqJvM/1z+ABtF+MCzfSVaSVUlBXfTy0VG 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Now, instead, suppose that the equity component of the manager’s pay includes a stock option package, given by the attribution of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABcAAAAhCAIAAAC9a6dHAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAARRJREFUSEvtVcERgjAQvFgL+GCoACvwZwf+4ClFWAB5ahW+QgVageODpJd4 l0AmhIjj8HO4F/H29s69JTCtNSyOzWIGIlhZ4jKuuqy6/PKC/bFfFN+xIap2RpS2cjjGdlwZKN51 WsumACga6Z6hFCYRhCixosdpbU4GaVjo6HJ9NkqDQA9nmxMNsRhOv2ryQ2yuoT1V4qZV98RRsjTQ 4tnZvzwn0e2K7Q/7+L2bZjTpt1D8fMVBLvsFt7fixxoaSRwfWOTrAZBvk4/ToC3SOhf3Uw9BXZJt DvB4yXHNVCiXbyui0HYMG4NbvCXNroi2629blHiyrvPd5DtwYoOQgyody4C24/mtxmaybg0C4Wz9 2kc99AbwKkq4HtO9lgAAAABJRU5ErkJggk== call options. Each option takes the form of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAHAAAAAhCAIAAACOULhOAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA1xJREFUaEPtmD124jAQx0XOYqfg5QTmBLAN1bbbmRKadCnTbUNK6LZNRRM4 QXyCfRRr7uIdfVjSSLYlyDjZt09uEtvSX6PfaD7MpGkali46And0UkmJE0hAic9BApqAEhMglksn NAElJkAsl05oAkpMgFgundAElJgAsVw6oQkoMQFiuXRCE1BiAsRy6YRKoJeX2WR1IoD7OUBPq0l7 zV4uBGb/KxLcD+2l/AE/MI9/HUvGim2NF6q3heZSHqOM4Dr2FTktoO2o2qLWK/XYfwLqYityAIva yEcH+UCFCYqxJBuCY89AW/iQca0q/wsWWGSUrGecfICPx9cDdQgLtw8TdX0Ce/DO/PVoNQkFtGlg HWSIg5jf+utag+5Ym98gBZiMIPKBc2tirSslmmciS+q5nZn+dNgz9nCftZLzJRDdHwaKwuXPbxzt 2fr9fa0F6HLqfNfs5kbu8vZasXIpn8Ae8/NTM7wu92qbzSR6ndusW+0U5DBxsIy/8K32OUg6xwtH L7fAUeo4ajJ3hfLC1WdUbbYoSxHy3qUt5//0ru6GfMextjj5eUUv674ypHBEBoH6iLv3NgpUU2c8 Yqhe9XsThXxPtFgBGR9P2frXtqg2P2YzCA3qiIRgFIbvF5Oe3stKRbqZsf/pmQbCKixBGnWjItEI jpzsYE5qId3Uh2rD803l0IbUdiyrim0frUQU9kh9BqGwD0FdbB181tXOcjJD17CLIXdx7f3CpH1u VjHNwX6Z5Z/DTfS1QEWxOSxRT4F4nVYLVpbVJh/47sjuHxirzjUGLS0PXtn6CfbmzQ7OixkgIsyc RF47i+/fROmbP3JHvr6FPkuuBHr6uamK/tMHuJ+n9W63gwixPe1uJp/y0DVV3a36aDyI+rEaST9E EWLNd3yrLQJeh41wZARRXWNNynUqhH2LXqmMrSfCfU/J9xt7u6wPrNdhXUTPGl/rtZgqorahfl/R uzSq8rpLkul3+FY1ONLxMFwzdXotUx0FYh9o2ypJJdQqd/G1TxpBP28Rd747W3EHg91cdrRPbtsU 79EbR3YC7dMa7PhuNCA4Dbd5weHOgJi2KZR9RnoPCXPBjuhjZaSVRpK9siiNZIWR5Y2R/ek3+oJq AbIv2c8DCp0Ub7L/y99DrX78L/djJUx982wjAAAAAElFTkSuQmCC . data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAoAAAAhCAIAAABvO60fAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAIxJREFUOE/tk8sRgCAMRIFevFgC9EM90AzNQC8xfIIJo14dZ8wNXpZdomgA UPdlHhiiH1/O57tjUfg7UCUvL+cTEM7BKmVD7q1thZRwFU7YeVt2tdQyv3F4t63HyZrRKJds4cmb BRYLwfFMcTasGKC5kIUp0blYlo9t923siOZFi/cecaacDwdAv/gED+mj9Otdjxp8AAAAAElFTkSu QmCC is the equity value at period three. This value can be either data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAJQAAAAhCAIAAACwWRVFAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAwNJREFUaEPtmT+W2jAQxu2cxWyxjxPACdg0W6VNByV7iHRpoFx3ucFWcILl BDyKte/ijGRJliVbyGM7ZN4bNxjLEj99n2b0h7SqqoQvmgp8o4nN1EIBNo/wOGDz2DzCChBG58hj 8wgrQBidI4/NI6wAYXSOPDaPsAKE0Tny2DzCChBG58hj8wgrQBjdjrzyuE53Z0KdIQcM2k7JzGmT 0GD1UOHPWHGdtq2S7Uk9Nx/FYZWsDoX7uF3Rf0FU05ffqNda/AM0cBVGmg04LHKrO7EyJtCm5IUK 4hMEll9toU3DbqOywDysX7Mr6oaFJbUo0/iHBm762o00F3BYZLSMYJ4xS5knw1CrLBoW93a3THhA oe2n64+oa5VLxincwwPLPNGPNBew9k4LKUVoREbL2Dnnbd6r902d7ODW3HspFwo/95l5nD0t7VfO H3mSLJ9M+eYVlMs/5lgRxQKHkf4hcK2sEhktI5iXff+xSvKXdP37Nm7ylp3fvirby68rjPLnhdPm 9asc9ysjgMNI8wFDhweIHC+jiLxs/ymC+JLnFzARu1koj79yyIo6ZDscWjw3i5dRBk4DLBDCSL2l 510avNZHb4TGMg+RUadNkR7rOQtiELHbK48/35JDEbCuzy6EEDqfjwEeNXqEWqHLnkysH7ov8jAZ nTlPrTkHxh9sPBdvy1MPsqEvbpfWJNjMqgghVKs44DtIurgbeJTtonIf82AZ/QVLtv8DEThgYXHe Cee8ZY1cvlxuRbuv/iQ4Wot44DDSAGBktmi62sGMkBHMAxJ/nosVGUbLy9VKl+edyfdyxrAGgbuY Q7uGBw4jxQMPT5t3mJEyqsMVtQUReyBnt1OntM59nnza2rm3tyz27rO7gfgTFetNs2GENgcC1wdC CtlHmglYH670iYyVUZywuGdjLTvs4yIdK/YO3ouf9jGMdezTdbiGMg8P7J4EdiDNAxwU2TnpqxWN kVGapy41kJGCPqAaOeA6hU02ivlfBfTU+/iKKQyGx1MwAUoBjjyUbP9Hpb+ionWPucSq+wAAAABJ RU5ErkJggk== with probability data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABMAAAAhCAIAAAC0gAc9AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAQ1JREFUSEvtVbERgzAMFMwCFBwTkAk4mlRp6UgZhsgAUIYRqGiACfAEuRTg XYiMbTDESe5IGdRgo39Zfv2BMQwDbApzE4uRduY36XaFdoW4Ar87gWYHY4pzsxZWTcssfhP61Edk XOOSRR2rO5n3054lZyxokCNXIEWleTcVNoF2d8S5ttKg7fpAioqOr5oyB/AcS+aDI9bNy8YEy/EA yKN/4xlNYYa8d6gtL3LN+BEANIsS8sF7rCMxleCG9yaJLbSN4MQ0UhrUluHztC6tEBYfbQgvN1e5 /QM78hyNE2hVEPBPIddELwNTdD7rzThX056msmSuUYo1VCeMa8nkHGX+y15GX/GQpjD+5I/0BCl2 CowFz0qrAAAAAElFTkSuQmCC % or $data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAIsAAAAhCAIAAABm/M8gAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAwdJREFUaEPtmbt1wjAUhuXMYlLkMIGZAKdJlZYOShiADWigjDs2SAUTxBNw KGJ2cfSwbL1tCcO5OUduiC35+rv/r3eSuq5RvAAr8AKYLaIRBaJD0NtBdCg6BF0B6HyxD0WHoCsA nS/2oegQdAWg88U+FB2CrgB0vtiHokPQFYDOF/tQdAi6AtD54Peh22GWrM7QddT4RsOG79C/82Zs YPwfvO6q9hnK9pX0jNyQ58K1PMk1xGK1TIvl8+C0lNLVY9uAJWLzazzyqMAsOQe2v5KIC9ZGVR1i Mbs8WMXunpY3L6l1fdxQ6/K45Bd/jd6KalqBmwZlRXoUMEvAgR2mJHWIJEuSF9m5YIZnVBsuFrkR TJXK7jaIQ9GP4dDiR23ALB070qOABYPM2IFK0nlo/lXXX3Ov8TN7m9D65+8Coelryl+ef2B5iu9H zOyYkkM6gd1ITwRmmgjYRoX7lOxdKaTr7RKVm8Xh1sQ/r/ICLbdrasrt94Lba+NWB3D55bW9bBcr p++fGSryZLa7+sVwIz0OmFE6sAOV7HWI9bDTdDNJ2JUjPOTYe9zkTVpU+KkrWbT+IeNVWRQlduqe 9bYbyVp6XjUZW35mbaMdih2k5ACHyMo+v/AVXrW/5EliprPbEZYtbRxsfsW96dm7IvJx1/XDhhHD ZcMOUrLXodthsSmz/ZHjpOsjlqzc7CxTTXUtpYmpHYwDsyXv42mf+BTak8xIXFl3afgYoGEHKtnr kJ5A+jptuenf5bWSE9EnpnsSZeM7bRhDliBuJA/gwH4vpSpiByrZ6xAdpqWZX5psabEgnLpUCrYG 66PPPYOsdyMNBw4a5RzYoUqqRwramQKbB7r9Bd3xqNsNcXtoOpTw3xm1Gyv8fRJR2cbI20MlvIio 70Lcpf6k0hsu7DAl2ZmCchZBG75x/97MCiZFWG8Zxx7T2YkUuQ9YPHgxIAnHMiMCG498lPjSgZD+ bQNYgsMGj0RPeREvgBboaF84PQXC/yOjYffOQ/5s8Y1RFYDfh0ZN9x8Gi30Iuml/aQWJ3cf4mwUA AAAASUVORK5CYIJ= with probability data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACMAAAAhCAIAAADcc4UFAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAWxJREFUSEvtVTtSwzAQlTgLpshwAuUE6XIDOrkkDTego7FK0nEDKvsGOUEm Ray7GK0Wfda2FGYMHgptJevN7tPue5L5MAxslbhbhQVICtOSUZfplenRCRRHFEf8L0doVSudFCWP ptKsy7XachLV4RwS8miUXHcjlq7mPGyaf+7QN4Ix2cJyJrJoK10mrETThwIBsnsLb273eWRyv4Ne dnvJTpfetaXV61G27xaysZDJVBCbCktVG8HOV5RXq6cDa14Cz28w+T76y4k9Ptx7no9nWIfwOglh xMIg40YVE2ikIVVsqjqzakGCK2+TCVkeBQYMrB4YsZI7OjLRwCZiG8X4bXTMiK6cY7LHSrs+g0bd xx63a/CeuWDb+EnQV3NvvaXyKNG8ezOGGxvBuRJ6sof008LpBkXzaDRXelPjLygpcXpB1an1bqHf XKMXIXYGQrM6JZ6lzPbkKaLnhwlxs0Vm/Wcfy1+jnx5tPaYvy5WjboCPA70AAAAASUVORK5CYIJ= depending on whether the manager chooses Project I or Project III. data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABYAAAAhCAIAAABSqcx5AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAThJREFUSEvtlrGxwjAMhmVmCa/gmCBMADRUb4RQsgAb0EAJI1DRABO8TPAu xUt2MZKsxDL2HceR4hVRw0Wxfkmf5BzGWguf2eizcIoeJDzDgcXAInWjet6L5jAz6/vbV7eHKgA/ OWS3Ishe3MQfvhK3Oowekqj3OUC+r+kXXfyoNZxHu5wDQygRSnQhIsElxRLeQ+cknCSSLOZHe5z7 xprruYRi5Tz3tRlXW/uzydoDKJEtv3M4LcxsV6WnUVcl5JMxh5vLygb6GBLhDFqISEdvmUVnDhKZ Pujp8iBijScJmYs+SYECjzUUSJc8llAjatvootrxq9J5IggpXmvGh9b8/QJMvwR/ttkWUJ6vTcBd FpNaxByUT1UuSxvtagCEG3na7rZuj7eDmCKeYhF0+vqhh5tq/sWfgwezDOlZcLliYAAAAABJRU5E rkJggk== is the strike price of the call option. 59This can be generalized by posing that Bank Alpha’s manager is paid with a number, data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADMAAAAQCAIAAAA0+9DlAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAYpJREFUSEvtVj2WgjAQDpwFLHicIN5gt7elwxIPYLkHkHLptrWiWTyBnMBH IdyFTQjJZJLw956FxaZRJ/PzzfB9g17f9+Qtj/+WqDiolyLr8r23z7vNzd6Onne8mWHsaQ6nSuVN Wknbls/2Qgm9tGMI/zUcMOFkvBwqxAzYlwAw4chyTmWbAYqjVFkMV8QL0JRSjMyqLJHxgLlhwUhd k7CAqeasUWhDNetxzGAbedblyfUQlRMkYTz4iuSD4qnvWaCzovu91vFOmrrnA1Gmbtp1zAs+D/Tx lDTlyBhxE/Jzz7LvcxPaTCS3skjPGMtSKYUzjEbCLUWM99CGz3Alp3gszPIUpSUSFlR8ePpZFCC0 vhKR7eaTtqlpFIob9t2dyaCE8TRxTLCLwaBnXwNSQSFkWBdKloaUQbjzejUE7dIms+ntYbaDaoUP d+baXLHK1H6a2FJmIZVSotEccC6AC+0NzmprbNmqLl/XEMCvSpeWpDZ24fwyZPI9soTA1RWfsBXn /f/XWCNM5PMH2njDPwnAD3YAAAAASUVORK5CYIJ= of call options, such that her schedule is data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAEsAAAAQCAIAAADRZRWJAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAgpJREFUSEvdVT12gkAQXj0LWPg8AZ6A2KSyTQelNuks06XRUru0qdIIJwgn 8FEIdyEzu7O7s4AaCHl5capldv73+5hRVVXirmV8191hc0N2WO7mI5A4/duppTFWMd+VVAagdBhJ IiGCbWGCFdtApeBKNxW6aImS7mWQv0xg0qlAeKVOonvcdg/MwKo0GVDf2iN3SKLLY7hWoBPcNkUt qpi/1CFkMzXzMysX1H3ezWnYhoZe3WjmaqzIE6dEIoSvAjJDsqBLpdMf1hRP3mIZnM6E/fJ8criY 5UWDm/40ODxYtvThLqQJlgsPC3oSb/uwFmM28VBDmFUjV2CWw3DGQ+9hdfrERsefyoFsDb/8ESSR +gEUwhjqtYSwSalD/cIWOmDSSM11Krw2qSHR4ceVDqnMRiL+C2IPU7OjpJeYTvpvbQuNS3+d1YCg 4Rfuq03uG8x5k5k1LPIsmPqXUOiYaiMI1yafKwk7kvTjgBgV3moTZe9HvRzULZTs55sKPG53CLYA cpnQjNboEsGpRMCHBOFjlK1fcTGWuxdViEB+065MYzMMqFNYvw5sRK6TY/i8FSqbETY4XTbgVOPa 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dAAAEnQB3mYfeAAAAHlJREFUKFO1kLEBgCAMBMGxGIh5mMNeRmAEG9zlTcgDWkhnqpBL/hM8APcR 2xeQ+oo50QRybOMhVaCmYFrRWCs00jtjlj3Gk0i6tK5hTAqKXtNkw2Lq6kTbs56FY2U/rnmVbUmz mdFPFbv9M4fjaUZpTBX/w3+u/voGA6KfmMpeXzUAAAAASUVORK5CYIJ= is the strike price of the call option. Under this different form of equity-based compensation, data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAfsAAAAhCAIAAABRO5V4AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAACWJJREFUeF7tXT1a4zwQNt9ZYAseThBOADRUtHShhGY7SjoaKElHS0WzyQk2 J+Ch2OQu+TSSbP2Nfu3EJJpUu5Ytjd6ZdzQejczRZrNp6EcIEAKEACFQAQL/VTBHmiIhQAgQAoQA IEAen+yAECAECIFaECCPX4umaZ6EACFACJDHJxsgBAgBQqAWBMjj16JpmichQAgQAuTxyQYIAUKA EKgFAfL4tWia5kkIEAKEwFgef3F31P3OX9ekCEKgFwIHZE8HNJVeKqWHB0DANaaxPD6fzHTOzn9t Nn/vjweYG3VRMwIXb9yUNvPpYaBA1DgMPY49C5cXo3r8seGg8QkBQoAQqAoB8vhVqZsmSwgQAlUj sE8ef/16rpL/9C9CoEWgagbzyRM1iA0oAi419sjjr/98NC8rka6lHyGgEKje4xM1iA44Aj/b42uB ClK+A1Z9c0V7vNW7txoBIGrUqPWtzPmHxfgTHsTPp8uPP3bF5up7efZrew6fc+puoUCGC/r/twL/ YJ3ul7QyD1EAL1Sb1VnNS9QoJMt+UaNc2kRq4B5//XoXqJEPtxbqhT12fP+XF2qu/31NH+2KzcXn bHp9Ud556ElA+bZ532zetjTAdsSusVeoNntvbs3F+fCBIGocvo77zjCVGpD+Wb1M7OFERMF/4Vat WdYQq4QSFEc7F7W6abetHQvryrqmi+UZBCnR1ualTc++alV143K6XTlYGQ8mC5ybkyyW1lCtXxlg G0GEBxRYm4sc0r0ibRLDn9fjow25Mqr7DfvPQkk9WTs1DBPFOdh6oF1ZmnJuqL2E2bodLgeInMgL LzUUL5rOp3uR5rPztSqn7nAt4O/lSRnXh4srMKLZxq4YeuEyySsCfVxADlT3pIDNvNORsu1aCuHM vsPeNhRbDmO0VIFzHVOxtHJ18mI4lsByFdKUJHDF0Eao6vX4rKFgJbB0ylWq208IJaKGFnEFODiW pXmJPAo1YkRO5YXH5w/m8XV/afpO12sbzszhjvkyYZHTdvgWr7HOOmvTu3IWB3c16650E2C9tyRv p6gbqfEqZMqt5EoWONPjF0sr1lxNXAvDUQRWr5TKq8IMvUGY2xCK8SXFM4JI17DM/kMoETWkLVtr LRYY+e0wkw/a7ftFjaC0WbzAXb6y1P47t5PTE/FCdnI6ab7+iQ3X9evtQ/PyOy8tzpKVrcasDy+s vo0yHZbTbxptG/fimnmv2ae27dq+IrLclt7V8a8zI33F6n+WTWx7gPXR5vchVZaZ6+fwpAvcN5nX pEobFmkcgbnl6Cphm1En34/4ZziOr24myAZ/AEBx4nx1+gSVyynbv2xDia2KrX13Rt6NGkOJqAGY hTkYw7A3IVQH+0UNTdosXrCbg9To7/GX3ysBKiumkW5Y+Pv3wT6Xw6xCL9NBiAjjt6tNwEa4eWke HkQ2Gc3RamaXR+fP33nGdnz/OG2WD7fdlvfi7nLW8C3ocoFjIhRLGxZpRIE7lUDpwed1YIWF5bsz vhhQql3GFY/fJ1HHzwME/xBRlIgaiFpMDkYxTFesded+USMqbTovwOUHqKE8/tdTd6IViX88rRDX y+AaNCmc6eL5YekW2xSrDiLkSBwOYsR/69cnJuI8EqSDR2DvQMvZbMk8f04BIcSQ87MH7knY77Jh mxKewdIEjk8J6psKpbU7D4u0K4G5P1gChrBcxouzEpZ5HEUR8Lfq8qhZvDw+dYs4hDLLgFZ0lIga GFBxDu7K0hLI1d6yC2pEiJzLC38EzD0+X2CaG1aeKJJAjHGa0w+1MjnnUxYRg4ObCWcKoa34lzo2 kvIK7dUAFGvGqR9VoHjxWOkumAcYWJE/uAORb4S5pXp9mO/lV1vktHr5Ys9mzVz/tCl2ZtrTWZm0 UcASbhhcYK4RnmiHxCOaqEsQK/0WmehhqsKxvXgTdJDauG1uYO826VwIUcNVA8LBRF0NbmmJ45bd Nri0A/JCxPiwwLT57uP7d+br9AxpuLX9HqeIZ2ENbz3/ycMZL71hB6q0ZEcuhnDW1kilIh3AK0+Q h8wZgzTW9gB/aw9EiWxDCfx+WqTP47+JymVJHB+eke0FngFzBVZQ4htW4c9KZ0nrghjGcEcCqzSb HV7nmk3a/YKaiGl0j2ubS+y73leNk9nXB7JQImro4OAcdPS0I0tLsw9xVzY1BifygLzA8vjh9GWo VduwVUmeBsibmnAFChoxNfJxBVwCKx+va3RxxxefzD1XuRbC+pcSbLpm0e0TZwucY476vWKVSZE2 LNJYAoPRTOSnNC5+W4EHCkpSuI09KXx9+0qWaBp8W7kVkGdLXcP22GHN1AD8PRzMwrCUFiKo3Sdq WNLm84LN2EMN8PjM+I13WnM3JdxqKIEl8NENW72Kx681zsGnL+axVOKUr6+O6Dyvpvk1e7/fGIOF FsDrjtOLOzVZ6Mhai5gUbhYnsJp0Y3GhjBcGhWOWwDl2XSwtr6zyYziOwGaWTWyFu5/baPGBu1MU Y+Epc41Pp/yIYdZf44ENKrEXL34ZKFVNDcjv+jiYgWEOMbhXKyPyKNQISpvHCwZTkBoyZapqntGD RF3BbOC4k1mPr/8Pqc0PltBrp1y0Yng908Ef108PqYpes2ennNusDnbr8bvH5RkAtMAbq8eXiX9L kPa/AYHLS461g2zZ0spncQwto0CnWyZ2CF5RL6+Xy/utROyzbLse3y7vds75Jaq1bmpEOJiIYa69 lRN5DGoMx4tYPT4/c2v9rbjwNwc8JxdNo5Z9CvY6Te2I+FkY6wxe6LSvXPUNkQwvIQ/dmNGBc7t7 Cld7wD3ra8Uajotq2y2kNFkKTn/6DN6aYZa0ut4951cxhHO5Z97vEViEEvzXAqouITbgOZmFLtDS CAtRl2L4no6rtXJqxDkYscNSe9svagzEC9zha+cthcfv/UOJpubgMjYWvYnwzT5r21tOpAPfoc5d jD3cfPZLWmGWhR4YQPOexPV6/OGgzuyJqJEJ2NC397O0oaWJ9ddb2ti7b/8TWDwsg81pJyVqliqk Z+HkWabnxU4+ic+KMVY3H3o5arqkdOcYCCQWfYwhGjImUeOHKKIGMVKoEVtzttQeivFlDNdM2G9n f/TKzehvaebUbR8EYjF8rL3P2Dt6lqixI6APbJig6avGgWL8oddPEeYvt/o3UEyZed11YpHe0LOl /pIRQCPm5KcP4UaixiFocQtzSKTG/yUDVsqfaJjnAAAAAElFTkSuQmCC holds, as long as data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAFYAAAAhCAIAAADME8vZAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAlJJREFUaEPtWLF1AjEMNZmFUPCYACZIBjnKLJAyA0CZFdIHJggT8Chy7EJs 2bItW/b5CO9RoGsSjCx/fUnfOiaXy0U99vP02OGb6IUCoUCqQBpBtADuApFDoUCqQBpBtEDk0L4c yI0gFNAqOG9Xk/X+vq+Od8AgjaCU/snEPLuOZL/buXX6lVuOjGPDsOW6/9owKLXc9OUDiJOiZb9Z QrwGvqEAPmtr81evwUcSmt0QLdkF/gCNoYqRR1/BAEF5lzZEnvkmyywYTYEP2VEAJZFTEFaMXUsm RlRIDUPCaRYCqdcYF2OJTMd5YClIEkXKwjDdFpsrtqaSyCkYKPUmCFAVafFmO30j6FrrOmiE7DGe IJD28CMfrjkHmEC+ShgSabqKgZQR5zOXw8w7EZims5kMopPa/nBQ2SoXqlK5ZJaOAVRCIymQF6TA OApfxhCCqwKLI+R/UEUKGPCI4f1lS4zOlyNKRUKBuxfiDvJt4G7Opt5mm6ks5cFc42IwwPf/KAC/ nYK3Oc0pSM6KGAjX54jE48TRyJylgIm3XYcKlsxlYJf0dLhfM2Pxcv4Ms8P596jUYja1g9P07b1T h6/vc8sUbWZd/XzMYZD5eXM+2K1VDBrFdvV63PSfL27zfr3a8hjKltPZQqnDqY/O708HHZyuAt/i LgNx3vNBpEUQnK6NkM4aBugAUkTRpEDh1CxR6zwqHKSgEYjmh0ks0k7cxysm6YvrpsMShhydzSJS QihI4qCWQU98HdioOC0Y0+m3tkUtuLXfij95U1QTUwmP/UgVqD+lvYa//YAj1AAAAABJRU5ErkJg gk== . This means that further leveraging the payoff schedule of the manager by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACoAAAAhCAIAAAAgZq7PAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAX1JREFUWEftV0tygzAMNT1L6CLDCcgJ2oPAsjkKWba73CAruEFOkMnGuQuV hC3kD5CZdupFzSYxetaTnh8iKcZxVOmul3TUyJzpE+qfxc/iJ1IgWy+R8HnoSus9ToeiHf70KBI7 X8HPDbz6xum66c19P1R3eo7435wki0jd1cSFHEhPa0DjJ9yjpeGnhJxoSi9L84rcQk7MIgHQM52h JylmetlFsN2h30DaLqVmUfoNeePte5tIKYGUms5QFh80bhoSf+Xycz5f58LO0HrLBcQbiJUQIA27 dR1aiI7K0mOSORgrAaOrvuc6QqTNzPutiTx64//A3j9onBtza5/0CMfO7uMMfX5dxPgb2vJY9ePn 2+ZEfB5Z7uEZvAH90EZGbb0vDReM4vdbp5l7aA+nR7SOZeTutVLqetdim75flapAfDYlKIwC4do5 JEc1iNq16+bgxAXS+oo9ZccZnb03cQWdF5mqj9KvIsmV0vbWXKH11p77X48lfuMV//oP9jcu7x8Y ABj5MwAAAABJRU5ErkJggk== will induce her to prefer Project III over Project I. 60Mathematically, this means that it is always possible to find a value of such that Bank Alpha’s manager prefers Project III to Project I. Indeed, the condition data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAATgAAAAQCAIAAAANlfTSAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABWFJREFUaEPtWjl24kAQbeYs4IDHCfAJsBMiUjIRQuLMoTMSFEJG6ojE6ATm BDwCo7swVb1vkrpBZjQPdTLym+5afy3dRedyuZDHXdms87Jx1E/2l/XocY3Saq5ZoCkI6Tx2oLaY bC3wf1jgjxIzT587z2leJjekl84sgx0lH6F6l7LD/6SLchMrQMJQ7qX7pHa1UJNEkCwubuTauASY pQZ/VdniQbDBzFCb70yrliEEKiqs82pIhqsz+6N47RO+yf3AQ/skhIiPHZzkC9pOtsESx5SQ72d7 8L9wsaNRS/FFAjrLYF18/HTxhHRcPJPuTVzqc1yUzdhmaTlhtKZhQ0cD80EAwF1DNAUhxB8Wfs+B vjKOrA9+wA0wDyV3E1jDDFB7i3PEjFv864ow5UHOT1Jvas4M0qUA4oZ46GspnR2at3Dx5LNrHWed kw7x01MaScs3ChtJkmiJ/oYwbQ5CsPXNvz7J5LVb1dsQcj4NxvSRxf3gh7uvE7JY6u2qS9XDbvS2 Ou7wVHf+/T13JXGPnE+HoZIZ/kqYZFesYb9HT3Xn29XwcDoLEiG6FLFT4kFfuhtfih+nfFygA6q4 gzC+NTouxm55+rFJ9vK5jdmvUdgg/b5SKFueJtCgBSHcb4YmIAQCFdx9GDwZ0aH3yvDNLoron+MP 3GHdD6Uf4G5IN9E2XuIN4Cqg52GXp9PPSX9XCE73SP5zJErmbLcRtowBHIO6pTsTnkWu1CWSKgHx EBh4eZySbfkLsofLaH3Zkql+n/UKUKvjIlRUaTGb9RaDd8iszcIG6b8+DXjKzWYf/TFxEB6sblMQ oj0mCdnxQfrILn+T03L2QXjyhGp3oeXO/TDVRhNls91Y3s58uUAeATQDmL/n8/X7qWe8HRUbE61H Ni/sbaYDE5Zr86Vbiq2UpVXYYN9SdQ+LXqe3IKutp0FwKLlc0Ma4RMCGGOZmx4VpyNIife6TvUKz sEGeur0+rRd5uutv5wTaL942hamo7WoKQtxART9IeB035P2qkeJovR6Bjhz2xa0pFFOWk2GBcTe0 Aa5c2Fmqpy+4MVnhxeu5CGT1r1W0zVKM8VXhUNFqWJQtslw8SFSHz6/SZ/RKTUXAjneqPSk4dLvj lHYwXFZ50NSOdwso2J68BLXolsC/jQ1+P4N2PJ2exvMuGsZtfMNc2RiEOIGqaYVXoNVb/NWPgx0o sYsj9kVFAYCYFskOviuBSzeYlpd89MPQPfqWeQHmmOPnsuXikPCcIUlZcgeRFeJ15+9JWKSWpAc+ qMLa5bu9K51rcJzSznhMMvmq9IuZNbbjuAM2joinLvS+i5cTVhnzmiQNFuTK5iAEArXgKpbNpp+o VZ6mQVWOWUC19KgjmixPl0Bn8ETSGR3SOuy4rzGcif9JyDpS1wUVHkDkBZX+AEV7ITF1CcsffJcm HjyShbyt2U8ENBnxoStcCzDj+NqaWh0XqqJWYjCzxbSU98AGiMe6K0giQ1plAvqkYt2bgxAxnjHm B1RwGCjQGVLU9EkfNqhhokXHHKbYI1RaCD3jGSGh2M8GHsZANWocqG7QQl3r+HWDE0M8zqNsPuvj YsxzypQyLKlxjndc6HgGxYXZB4d21EjsftjQxLphxi7n84XK3hMhNFDZbwairO6FT7DglexcSpVH oqK0enOwLtWkjB3mHPVmLr9klsI5qvxZQ6TawSPfaij+e2zImIkqYqEW8yOEB6ooTtdzxiQedbr0 gCx3RvaI5hFqG7eexOkSxkeUPPnrrkiLFXG5l1lYQr8in0cL2GBsMCdEa3QzQtof5Ydeztp9+N7A RmkBP45pzVWvBdpArdeeLbXWAr9igb8Uc3icGwj0KAAAAABJRU5ErkJggk== is always satisfied when data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAATAAAAAQCAIAAAAeQrQmAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABWpJREFUaEPtWr1y6joQVu6zQAqGJ3CegKShok1nStOko0yXxi7DzL0ztKlo gp/g8AQZF8Hvwt3Vjy3ZlrUS5oScExcZE6/259OutLsSO32f55hGLN5/H32VpqB3lB599EZL4YnT NIr/xXccz/9pvPiwxOGmFm443RReGpxP7InklcBosXsf4xy3nvNR+m0crs4/aJYD8H7xeExjHr/7 2G+cSx1QRF/P7HAqwmsD3A/JL4fRNR+d3//pjNKffwYikC9v7rLSGJzvNvE6GdEZlu9v7Bbo893H 4sFjnFPCbB5vdrmTDARv4vnMTXc5ig4YQZgfkl8OYxg8IiABAHy4L5XZHf9xsyTMXVtoL6s8a3hr mNJqlJSlKyq0bwaFW4yudgWBJwIgezdJp6Yw8KJoMnYrUFOMbqebezDi+YOtxv6W9IgaTyJCRMJC kD5Z4xGB8sTFx3ig7YRRxKMPkl8No9Nq6XIi2GqXFfsmJidVfoTJbXitZmUlc+bwNKydQUFWEsda aSSKhiAJhtocDwcERglQiVR5klY/uhgFZTZhg4wazGKjliibFBLcyImMl240GKWLhnull04uYgqM Lh6mRVV/4CRT1mNxiER+hOvT/HR6bS2R3WlEex2ws5rv92m6X9861w4ywbFgk0lNnb8UC2hdBCV6 tdrID365srbZq4b5L1tOimz9Nkiy8WGEh+LYN7DMnm2J8ij5BRZvF2FybaNoMIopuSIkHTBSMVIW jZJtGnGeIiDLzw90Y8z3Htm2HYxIA8ht2aO5vXbItbOawZMk8KdZF5l7t9zCKXln+ckmD7dTCU6+ fJ7M2dthigWY7wNqs3qgkR1x9VTqCBDZs0j4OF5t9DzTZOur1OD0kMaxj0+zxjWEYOEVtJ65VT0H RuGi2gS5xV2SwgkjSThg3fBVnBoekPjpsBrfjFcs3fb0H8QaCaukDMyOWoLKSlfZWCTrbce666ix omyHwggNKbPdZJuwwGUU1Wa8cuPP/abaZvPlbi7b5xIpe8ArfJyakybsC4guF49/FYy0mWtnYehZ PCAxGxAHXYe39571UwlSjjfftfYxX1Y03bupjsVUNQOP2WMxT0a4szUWeNr2K9WWqwHUNVXUzV5f Z/BV/iaksi6Lqgzgt724NKq+QzxOvRrCfCQJ4b8JRhIgjR4V7gg8f8WAVG48StYxLSJlJxaLTXM3 8GdFndG2V0E3EC2A/OGwui/WkGh3pTWk7dcM5Gbbv/oNBZZXo68zEgjV/sAk1IDMX1bVCkcdA3Qk hIWbibr8D4eRBogs7STOAP1BHI5BQGpuPHtK2erFftyhYh8KTXSaVrHpwUqbceqMmk4C8yu2LchZ I96nr1YZD2/ipD0FpPjK164ye3ljsHWybOl1eNNbtPmqekH6Cx8/ngsjWP5dkKRMUp11YYpxv4n3 MppU25l3lGWx1Hlu4D4MIbMK3AH0LryUpfXBVaHn3Ro31IbrMRxOHYL6X/zN61SFcrmEc0W12y9E pKgcjHOMxrFH4x6POgzrQFj4WyjOAJ8/jPzekgN5Kgh2TKkc+mAkzVjdlGhByUgMroOIcDh4HYpq WlB0Bhrh3e0Xoj1UDoZTm6p13dOjKE/U8HwypzJUEOyqUDn0wHi2nT9X5yj5RTjN6GHhvB2Dp6n8 Lk/7pU+wdo5A5GDWLTrvnuPHcNuHHelEkghCU6shYRzA4p+AHADEPhboR/21T1UMt18U4/aVQ3l/ 47QuoOQncOClsvWQ8XLHHQOi60CSBkIDyWFhHMLYn4AcAsXeiEzW00ajTDapl1l2t/wPOre8W4G9 R/Olh2v5Xiygj4V3IZ7GRA7fPB6hn95A8tpgHMST/geNzyITe7M4ygAAAABJRU5ErkJggk== . For example, it is apparent that when data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADwAAAAQCAIAAADF8ItoAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAYhJREFUSEvtVjFygzAQFHkLccHwAvkFGTdUbt3JpT+RLg2USefWlRvDD3iB RwXiL+ROdyCZkEykFHFmcgUzMLrVsrs6EMNdV63EQiXAeen5XT97uGt2n5Aj0s0+wVpXvRB9tbY3 yb6JeSGG8psJ0YKHFqMRIQdBkTalFLI0dINBUnVs1k2plJITmIUWDjwQFruZiwWyuBwPo1u53aSA DrKci2F4fQoVZVxvtMgy19y86G0pGTwKU2aPti89HEvZaiMEke67K8KijztxXCZ86xQb9tH1vhPZ ZpVbcMzdc1aIU5uvUJDw6i/z3msHKRvDQYDO1UAbx+XgIbgJV0SCpMAV0hYNC71eUMesWKUxHHYP 2Z4uEcfFU9DovOBkmWqni0PanN8WwvE937CXw4F5ANnplg4eS/GVKMtzfiZirQjJLrYaeScp2Dw2 jPvcfADSPuxPtiCu5Oa03c1YCmXthcOpgF/DUcBJlvhkM9QshJidmAFKo3IqH+L/Mx4+0uI6/vC/ R9wL/1rXOzau2REHAULnAAAAAElFTkSuQmCC , the manager always prefers Project III to Project I.

This stylized example explains why increased risk taking by bank managers has been recognized as the most proximate cause of the recent financial crisis. 61 See, e.g., Lucian A. Bebchuk & Jesse M. Fried, Paying for Long-Term Performance, 158 U. Pa. L. Rev. 1915, 1916–17 (2010) (describing managerial risk taking in banks as a major cause of the crisis); Douglas W. Diamond & Raghuram G. Rajan, The Credit Crisis: Conjectures About Causes and Remedies, 99 Am. Econ. Rev. (Papers & Proc.) 606, 607–08 (2009) (talking of a “culture of excessive risk taking that had overtaken banks” and relating this culture to the distorted incentives of top bank executives). The popular press also has largely embraced this view of the crisis. See, e.g., Stewart Hamilton, Boards Must Stand Up to Bullying CEOs, Fin. Times (London), Apr. 19, 2010, at 6 (blaming the crisis on excessive risk taking by bank executives). Likewise, regulators have also backed the idea that managerial risk taking largely contributed to the development of the crisis. See, e.g., Press Release, Bd. of Governors of the Fed. Reserve Sys. (Oct. 22, 2009), available at http://www.federalreserve.gov/newsevents/press/bcreg/20091022a.htm (“Compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability . . . .”). Some scholars, however, remain skeptical of this explanation of the causes of the crisis. See Rüdiger Fahlenbrach & René M. Stulz, Bank CEO Incentives and the Credit Crisis 22–23 (Charles A. Dice Ctr. for Research in Fin. Econ., Working Paper No. 2009-13, 2010), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1439859 (arguing that empirical evidence dismisses the role of pay arrangements in inducing risk taking by bank executives). Contrary to the conventional representation of managers as risk-averse agents, the banking sector’s reliance on highly leveraged compensation schemes led managers to undertake increasingly outsized bets—tail risk in the jargon of finance. 62 See supra note 38 (defining tail risk). When the market turned sour, these reckless bets led to massive losses, which were compounded by two key elements. The first is the inherent correlation of the banking system, which may cause increased risk taking at an individual bank level to produce systemic effects. The second is the liquidity production model of modern banking, which has drastically increased the opportunity for risk taking by bank managers. Section B addresses interbank correlation. Section C explains the modern model of banks’ liquidity production.

B. Interbank Correlation

Modern banks tend to be correlated along two dimensions: the counterparty risk dimension and the asset dimension. The first dimension of correlation arises from the high volume of interbank transactions. 63 See Shelagh Heffernan, Modern Banking 66 (2005) (stating that interbank claims have risen from $1.5 trillion in 1983 to $11.1 trillion in 2000). In general, these transactions serve to efficiently circulate liquidity in several ways, including intraday advances on payment systems, overnight and term bank lending, and derivative transactions. 64 See Jean-Charles Rochet & Jean Tirole, Interbank Lending and Systemic Risk, 28 J. Money, Credit & Banking 733, 733 (1996) (discussing interbank transactions and the risks arising therefrom). But on the other hand, interbank exposures make it more likely that a decline in asset value at one bank may impose losses on other banks. 65 See Franklin Allen & Douglas Gale, Financial Contagion, 108 J. Pol. Econ. 1, 4 (2000) (showing that the equilibrium of financial contagion depends on the degree of cross-holdings of bank deposits). The classical example is a bank that owes money to another bank, for example because its trading partner has unrealized gains on the contracts that link the two banks. Because of this contractual relationship, if the first bank fails, it may cause losses at the partner bank and potentially threaten its solvency. 66 See Kenneth R. French et al., The Squam Lake Report: Fixing the Financial System 46 (2010) [hereinafter Squam Lake Report]. In the real world, these problems are likely to be compounded by simultaneity issues because banks act as both lenders and borrowers with their trading partners. 67 See Markus K. Brunnermeier, Deciphering the Liquidity and Credit Crunch 2007–2008, J. Econ. Persp., Winter 2009, at 77, 96 (arguing that simultaneity issues in the interbank market have led modern banking to resemble an “interwoven network of financial obligations”). The widespread use of credit default swaps (CDS) has played a central role in the increase of simultaneity issues in interbank transactions. See William K. Sjostrom, Jr., The AIG Bailout, 66 Wash. & Lee L. Rev. 943, 950–51 (2009). CDS are a particular type of derivative contract where one party pays periodic fees to a counterparty in exchange for receiving a contingent payment upon a default event (with this payment being typically guaranteed by the posting of a collateral). See, e.g., id. at 947–52 (analyzing the role played by CDS in the collapse of AIG). However, while CDS resemble insurance contracts, a CDS buyer does not need to be exposed to the risk for which it is buying protection. See René M. Stulz, Credit Default Swaps and the Credit Crisis, J. Econ. Persp., Winter 2010, at 73, 74. Therefore, unlike insurance contracts, CDS are heavily traded. See id. Within the net of reciprocal exposures created by the trading of these complex instruments, simultaneity issue may also lead to network (or gridlock) risk “in which multiple trading parties fail to cancel out offsetting positions because of concerns about counterparty credit risk.” See Brunnermeier, supra, at 78. Additionally, banks tend to be correlated along the asset dimension because their capital structures and assets are largely homogenous. As a result, a crisis at an individual bank may be interpreted by investors as a sign that similar banks are facing the same problems. This, in turn, can potentially induce investors to reduce their exposures to banks—by withdrawing their positions or demanding the posting of more collateral 68 See Duffie, supra note 1, at 2. Securities are the most common collateral in the banking sector. Thus, the posting of more collateral typically takes the form of the requirement of a higher “haircut,” which is “a buffer [debtholders require] for unexpected reductions in the market value of the [collateralized securities].” Id. —similar to what takes place in a traditional run by depositors. 69The term fire sale is used to refer to the phenomenon that occurs when a bank is forced to sell a large portion of its assets at a deeply discounted price in order to achieve a quicker sale and promptly satisfy the requests of its creditors (i.e., reduce the risk of default). See Andrei Shleifer & Robert Vishny, Fire Sales in Finance and Macroeconomics, J. Econ. Persp., Winter 2011, at 29, 31–32. When asset correlation is high, price concessions of this type are likely to produce dramatic effects because collective action problems will induce debtholders of other banks holding similar assets to take similar actions. See Squam Lake Report, supra note 66, at 46. This, in turn, will result in a larger number of banks attempting to sell assets at the same time, which will “magnify the original . . . price drop and force more sales” in a perverse spiral. See id. (pointing out that “[t]he size of the . . . price concession depends on how much is being sold, how quickly the firm wants to sell, and how many buyers are available and ready to trade”).

Importantly, increased risk taking at a single bank enhances the likelihood that this bank may experience a decline in asset value, serving as the initial event in a chain of contagion that may drag down correlated, but otherwise sound, banks. 70 See Marc J. Flannery, Lecture, Using Market Information in Prudential Bank Supervision: A Review of the U.S. Empirical Evidence, 30 J. Money, Credit & Banking 273, 278 n.11 (1998) (arguing that increased bank risk taking can create significant negative externalities and systemic risk due to interbank correlation). Viral V. Acharya has extended this argument, claiming that interbank correlation increases individual banks’ incentives for higher risk taking by replicating the debt–equity conflict at a systemic level. See Viral V. Acharya, A Theory of Systemic Risk and Design of Prudential Bank Regulation, 5 J. Fin. Stability 224, 224 (2009) (“The limited liability of banks and the presence of a negative externality of one bank’s failure on the health of other banks give rise to a systemic risk-shifting incentive where all banks undertake correlated investments, thereby increasing economy-wide aggregate risk.”). To see this, consider again the basic example where Bank Alpha can substitute Project II (i.e., the asset substitution project) for Project I (i.e., the base project). Recall that the two projects have the same net present value. Now suppose that there is another bank, Bank Beta, which has $100 in assets and whose capital structure and available projects are similar to the capital structure and projects of Bank Alpha. Further assume that Bank Alpha and Bank Beta are correlated along both the counterparty risk dimension and the asset dimension. This implies that a decline in the asset value of Bank Alpha—which is represented here as Bank Alpha’s default on its outstanding debt—will also affect Bank Beta. 71Assuming that Bank Beta’s assets are Project I, the correlation between Bank Alpha and Bank Beta can be modeled by requiring that some mass of the distribution of Project I is shifted from the high and medium states to the low state. Specifically, the probability of the high state is reduced by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABwAAAAQCAIAAACKrYi4AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAPJJREFUOE+tk70RgzAMhWVmIU1GMBPkaFIxApQZJA2UZAoqmCAbUAG7OJJi c5iYv2BVvrP1+b1nWSil4HwNRfSEBCAuHyFAcB5IhPDxLuMR5Qk6k4b2fVSfSwbLvFdK+MnUVvqn fXwYERXD0oOQd9Ke1pxCnZqVOxTcH10uxgY2CXs4lZ/SsPUbTRfZH7pWXi8kgFZJjJNmVZMJUd2/ HeXNZVnYhUrRvFY3iWEuVSvVIW3MC0JNjNyH+Dp3BmAiZ6XrcEChqeQZw4PM3aOGDrrDp7sBQXso hz5I0FQvP99/Qgm61geTBoQrawh3yNfWYR3lBz56bldjJDr4AAAAAElFTkSuQmCC , the probability of the medium state is reduced by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABwAAAAQCAIAAACKrYi4AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAOZJREFUOE9j/P//PwPl4M5E626GMAYG75n5KgwMTJQbCDJBJf/oTG+4UVQy FM1pQO9TA9yeYAU22GrC7f//GakTpqguJcf7wFhhtJ54B09sbEsDS6ZtAwcCyBdQJpZAgaoFexEf YABJAhVDFQINxWIm1DA81qFaAfa+qhYklBnubF2lE+CJ4q/t6YyMGwIgmmaiSiHUMaIClDDd3n2t Bl2j58z//wM2gDWlb8cVjGhhAfY+0P9WE7Zh9TmycqJDAWYoNIURlWRBhuONrEGTTgkWF+QkfiyG gtIIIjKpZCgojUASPAgAAIK4p5FcwKFyAAAAAElFTkSuQmCC , and the probability of the low state is increased by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAB0AAAAQCAIAAABlb+OGAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAQJJREFUOE/dlDESgjAQRQNnAQqHE4QTgA2VRwilHMIDkBI6Wysa4QacgLGA 3CXuhqAyioYijVtlyO7j7Z8BR0pJLJRrgYnIP+a2mZO1prFZzUHwaFbZJDXJwwiW3kWzlO9461ga q566ojvfdNmpLy6lbBjpB6HnkIVcMfQahqfD3nvlahsQSipSJUoNKuIzRTX7OzoNieslVIpSjgWl xQjfB54Ia/D0qcBp9XJmNEy3gC+kEAbg2GZ+3oF4y5cuJql4QQggHtVpqfKEHMRAaI/71SnE1OV+ HRwXSZhwoafLT+SsqZjDQ31t//n5txzeZsmm7l+vft67Q2+457Y2x9J/8g6u6TjC8pWLDwAAAABJ RU5ErkJggk== . For example, assume that if Bank Alpha defaults the asset value of Bank Beta will decline to zero with probability data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACMAAAAhCAIAAADcc4UFAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAYhJREFUSEvtV7txwzAMJTNLnMKXCeQJnEobpJPKuEmXDdJIZdxlA1fWBppA 58LULgwBfgFKF9/lzk2IygRIPADvkTpLrbW4iz3cBQVACtJfRl2mV6ZHJ1AUURTx/xQx9zspd/3M uEe3s3YgwRhiASGGVsroNN/caKqrIEvVqczrfHZHc/bxc+NX8IscjCHcLJKUGGr4Ac1SwDJApdlo ZigpFmRQ4hsxtC9Tp75qfmeG01GI56dH79/XBup4CiOsthsb2mwrMV3t3Of+9SC6932SzCMhzvdb yBe2zNfJTMVnC26fUojxoqxXXUZXkcVh2SzSKs7SowC1e4Pfrj/ovamhi+HzMDYfWdVaw0QjlZ4V 48UxowQI08yDvKFZWiJdTl8mAucFRpZtBYlIgkjXFcYRbfGp9vDUoliJirId9Ja4/jNV/v59QloS rXEtJvMwBGVCCKrkPeW02DY9VUtx1xO9T+kK7xZFipyxZyIhk0XyxyIDtqAZT5zi29aL3FFVyvJf Y+3q3eD/AaYzoZ48Up15AAAAAElFTkSuQmCC . This measure can be interpreted as the level of correlation between the two banks. It follows that, from a social welfare viewpoint, the undertaking of Project II is inefficient, despite being economically neutral for Bank Alpha. Indeed, the undertaking of Project II reduces the overall wealth by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAOkAAAAhCAIAAACz7httAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABXpJREFUeF7tWj1W4zAQVvYsgYLHCcIJgIaKli4podluy+1okpJ0aaloICfY nIBHQXIXr34seUYayfJPXp52xw1gSzPffPNZmpGZVFUl+GIGCmTgR4GYGTIzoBhg7bIOSmWAtVtq 5hg3a5c1UCoDrN1SM8e4WbusgVIZYO2WmjnGzdplDZTKAGu31MwxbtYua6BUBli7pWaOcbN2WQOl MsDaLTVzjJu1yxoolYFTavewuppMFttSqTsW7u1iMrlaHaLmFW2lsXYUzKfSrgrmQWyq6uX6WBoo 1e71S1VtxAO/1q0JlP97Dq/9cibEbLmnbte25h/hDP3Ie1BVH3PippysnPg+tGN7BZb0lMjT5lE2 AC+6rD8RQIcFhqHCJR/UIZtnuSApkjSj4KJ5CtOHAAQQEtxmMdMyKIK5nU9ol+JWUDr0god6Nh4b zhp5qt/QxJhyQ0l7RjVOmJaxAfTKiESFpKJBuTsaswvfMD2MpeAVtyyon9I09i9DcumNLD31bY/s FLe9eCKXQgJzms9AtwS3ULtabHNfgpoTQAdSFtQn1mqNNgw/4NyQjnSBXY4MYHhGlAUvDIkRSgYL pAdLGiRaep1DxyzIvvVAb5sJAlPcDicqiZnY8MN9RA2KcdvUu9vFzedy/3LnVxnbt7UQl+dTe//6 Tkpt/eZarNnFmXl0djETn9+mxzisHp7E8idRyx7eX3difgeeHL4/5cthrThTu9d3Y2tkAH58/f7e Pj/tZiBAWaT+eXQcien5JbbbkSUzeXp7P3M0hDilT9stqBo52jkkCGzjth85iVkAMxrl8wkfxri1 2tXK3QD27WRCWeqRFakQu6+9Gbv/2tUaN8qlrJlRWKg6z85KEPfYAMZIx2H1ey1m97eNWD2rWhPw De3IUm1OUWNnKiGL9c3k6vmrWwgJAlu57eYpGJ2LuZVPaLnhVq/cYFX2y9ZwFwoqJLPS48qXXv3r YX5BhotF25fB+gzNGAZg+E4YlpqeTb8sAn9nsmQN+tloWhaaYKpmSGQwnVwUVeOZ1jPZIFpx1VNi ogjLyHiSwFhZ76KqylW38q521RqeT2eTHVP0qasJLAKzGapHL0EFPDIAw0r/TNjJ0ZeTPEUBDv03 nWLJpc7Xrqu0Na2R45hEq20MO0pbuR3hRW88RjAT/U7ULdKqSKQxot2wtQKumhYNrzCoTYy/ox63 iGiUUCJvzVxqI2jzmZ8lSk9udt4S0spSbN2tCZHB4G7Qjs9bd10Gw+HJ5OZz5I+UjqKYk3xCQz63 P4Qq88EFLOnin65GccXqdhHQoqmqpC74VHcXr2fDLUi3c66aPAGAVJWXLM22i7Ony4+27y0dWQJ9 MgA2fdzIbQ30zFHQCQI7cKu+9qWu1JdAC43CnF3qhty2f1dTxweQI781BZzJZpFs0eAJhPo9LWTV cor5L9c3jgxgWPvhgwPW5KdCfVJjj1C2CzqfOSzVZlUvZZcJKZ7wS3BkDcExJgjM59Zb4oIlGJ6y OPftmBN8wiBobj0Q1KYDWyn6ANHVkNRxvKmv3JPkrkrvhOMC6L/zmTqZrj5w12CqYmokPOvFXx4R S65KxGfyikWz/9JQIulJEJjJbT/SYHFCYo7xiUuXCLf4u1rTwni0g94mUjjinJjc1YL1HwVDQQcS K0tHBdAvEXVMNEKy+QuHdmAp/HTu+QjPXrwtJfjcE3TOhoh2bnsT5ndThKxIPpF2Y9xi7fbGSL4/ jU/iXyDG650c/4HJKIDecQ6b2ImlYLEB/djI5A2LKmd2vVfkDM0fM5J28x3WI6OZ6Wzpn5yQKqyO ooMjs3gUzBMJelj30n+2LMBz2vL+DsqcKRsc1fORzU+ZER0J9Sm1e6SQ2Ox/wsBfGVIMvbWx6fsA AAAASUVORK5CYIJ= (with 90% and 72% being the probability of success of Project I and Project II respectively). 72 This result can be generalized by observing that when Bank Alpha undertakes Project II, the probability of insolvency increases by , which in turn reduces the value of the assets of Bank Beta from data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACYAAAAQCAIAAAD1fJpJAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAPxJREFUSEvtVEEOgyAQXH1L6YHwAvsC7cUf9IbHeukretFjP6IvaF9AehD+ YoFFpU1jUhNqmnQuwjLMsCMB+obzpkc0PKkkDsYaLlRYH2hcQ2+SFU+SeaYTdPKWG8ME1YlbSSKN TFCC9baw89LWd7XSJdXRPDff+gyUwSxTsO3Gc7DDGAiFzigByDuz/coqGZnpxevyejT7JQAhVGQH OO1h0nzHvLM8NeeuzVlV5443xqiNwMbQcIDntPxg/dV5phFEOFknCi5lLIeCcR+7iLTLa9iB5/71 CWw1yK9g+aXOfJv/vwwU+grX5ycs8aHXKNplyX/eJT7f9iVehgc8LW+DOZkh6wAAAABJRU5ErkJg gk== to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAMoAAAAQCAIAAADYone2AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA7dJREFUaEPNWT2WozAM9uxZSApeTkBOkKShmjYdKUOz3ZTTpQnlpJt2K5oJ JxhOkJcicJdZyThgfmyEMey6SfKeI/nT91kSgv0UKzt73jkrvwfnc/D8KXaM/ZA9jLWl+v/EKOaA MAsX4+NPDAUrPF0DVqpLyM22vLiT4DoemdrC9CgmhzAXF+NpIIXiF8OVxJfg7ejw79OtjR9c4mQ6 +zOgmBrCbFyMZ4EWiq7cBZmPu68ntPGCR7vN/AWXoHL1dGyU5Jq5axIUGgjyoQvfJvGbBcV4Kosa rmcT9mBx7Npn5QAtI10VG71XPOjOok/HM6HohhAEQdW78oDqxKUBYoCCVKW0fBpa6GfzB4tjdk89 dzE+XZIspPesvg+9v+6ehRl+Bf6GZKmxaT4UHRCY61bHSU73V3hSqkANgDMfigGHUm9thQKvlQQc 5JU/bmy1tNd45dH65VC0WMnh+a04obNcsdsjl49b9w7tk6HSraGAM+MSCCQwGgjM3S1XItTJ4d31 2Z/UKKTWUIgQa7ggyMsgFF914EVrb3VVCYgglhzOwy5bziis7cXs0lsEsPngz7jVLejLpgCBLZ2F 6+Ff8ih2P49sznqgwz6Ii5ahwaHAQlgLV4e8nlSLT8mpUHNjw8s6kvMRXECRgPBbX4XAYlAN2IDW 1qWvnG4vkhDrTtshVqAgQWCglcIiSGfVV6uze7kli/Z3/+jgtWoDNwFC4UITFi0XtPMMCkUrn3TI q9EFSsyhmjvWtzzSwLtchBYTU1+FqBOBk4UWmZXTWgdac9pxgRUoKBAqa9BFvX30dIJJfMPGFep+ Gm75dkWFMwFC4UIdFj0Xw85DCYWcT6AsQ38h5NVoiEbUGkhHXFPJYRHiE0MS1XJb3bKtxktYtYYC e0SWRevY7xMXjgyLOwTX3Dv/Bi3itTJsIDkOayiwVNG5UHA+IBSlPzCVnELM6SAvbsDWyh/Mu2Er FfvQwaThIl5Kua0hJ1Qg1Luii04OkOXTcK9Ro+6QVlGAozR8Z58d4mpC4KUJETjHb8yoebQHUGl4 MpofW0Wh54LOOC0UkK6kMg1NNB9GWJ57XQPdSLT11mbQeO2/mHuNg1C+glNFyebcS8+FFHrDuRch FPydowEmhS56FWAyyCZq0B4KjUPiq1zikTu22UNhKBry0Smh4L2Xs3vlT9VilY8UYvZDT6NYOdSr 6jTpFgfstIbi30GYj4sBcVVspbEpxNohdXJuJeqdonaiKdW2qVHMAAGgTY1iZJCLv9NC8Rd9E8jg /gxp3wAAAABJRU5ErkJggk== . Hence, the undertaking of Project II by Bank Alpha reduces social welfare by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAIoAAAAQCAIAAABGGHAWAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA1FJREFUWEftVz2WokAQbvYsaMDzBHiC0cTIdDMMNdnMcDITCcds0o1MFk4w nsBHMHAXtqr/GxroBn1vAiuxbaqrv/rtqqCua/Kin2qBXz8V2AsXWqDPPfkuCHY5MMkFrKt0GVCi X3oJWZdpNcQ24bsObIIY29Hng2e3NlTAv0jCblDcOGUJhxmfS7qVJXwlF7BZnmPxXR1tr4CNKD4u mm3gJ6Qk6xNg/WbIUbBdAPncZQWvw2UqjLrWRQXg4bKJ5hsGAK+mK1jIHYXNyT0tJlNheYWPzSiv KYcf74cEuvoFggV8kiRaUE5wjpsKyj2suFXp+yXJPt5E+kQzWJXFYkN35MK1flT//pLtOtTYy+IW qx34lzDRI0iTw0+H6y05nAZrreNdNvAkitTp/FRsoYSYCjoKZ2zuKjD3KHvlu9lhcdyH1GP3b3g4 5MKOAGs0f4agbtIVKHhbzHXvVN93onby6yWmAeBNbclUBPgnplh9iFd5jl2qYQNPovV8cStKFJ/v 3qMNaSrofrGfCtQ9zF700b9u6ppmUbj/qr/ATWphh6B5ttPqCIlcVuzRC4LVZWzo9aQdt567nd4+ 8HUlyq0dCY3ZNA9nEQ2AKr1Gn3sCtWBcfOmZ0IJqUQHdA7GN9kKHZGTl12vhWYaUS7HZB0sbbzdo x6FlEmcXDYvwIP9tYPFIOyVwddEioyEQjM4AgA94JW/h10p7mf4uNvsQYbRL28NVQCToHrCeqDyA 1ysMVaHuSFqRnEodUK4dpxjKFqLpK0kPAEh1s7NvhLMSaLQGpkApGZ6To3x5TQfl1zuGXwjV7bCi XGalltwPV4G7R4vJ/HTwS1vhWXyy8GSewpzTeAoe9fDoYQRAtWjvCY3+YgdGh+hMl9eNdE4DPBiH hS4Ebnz+A2UfL5tS2kQmuKlABxnoG7kegz2o0XaWZ2g48SQcow09P651zmKaYl9sXb9bdy2mJWFv rVpOaKwRT3N8aYPXjDJhaJMD36AK+tyjz5wOljJskSVd7hw/2jhgMFiGBjHvuUcb/XyxjORvqqC5 Rw6fjqJlFLOE6cs2W2g63uLI9sQbnijaUK5xjyg2PKUDKG3ks+PFHOhS4XmeFUfWh7/oKRYIwJVP EfwS+ggL/AdBBYDOKO4iCgAAAABJRU5ErkJggk== . In fact, as long as the level of correlation is high enough, even a riskier project that increases the expected value of Bank Alpha may be socially inefficient. 73To see this, consider an alternative case where at period two Bank Alpha can replace Project I (i.e., the base project) with Project IV (i.e., the correlated project), which generates gross returns equal to $data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABUAAAAQCAIAAAB2uKNyAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAANhJREFUOE/dUsERgyAQhNQCPhwrOEvIPyXoU0vREvLNP1pBrMDxIfaCh4cI E51xxrxyH2C5Pe524VprdiFuF7iG+jN+m3Oet143U51yGx7u0LSelmStVQW4AgDLGlSDosnYetzb Gg5UCrVbCQbZ+MhZrsNaPmr3Z+aXsWmQsWnsA7W7QR3ph5Tu9aYJg0giQWdb9OB9UTwrVkrST5Yd xJJo/RgWPexfFB87PioDjzs+K6Jk60UNVHRfP+eDEzpUMtCfDFzDmWB8cyb6vi6ZNo3/y///tvoU MgN/jNadDheuZgAAAABJRU5ErkJggk== with probability data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABkAAAAQCAIAAABshEP8AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAASJJREFUOE+1UzEWgjAMLZxFGHicAE+Ak6eQURY3RzcXGOUITi7KDXoCXgfo XTBpUqDg4hOzNLTp7/8/wev7XqwU/ko4CPMnrDrzILalZqq63OLGp62sHuRglf0EvyBeByEOL8pn O12RiKToYBcyk9iVLw73BNXMgAw4AdBDJoeV7i0TUwd+6eddFNGD9DBf3TZOU6Tqlk3S5aUpTulw 4COUlLnaM4VqZ9XH4YbKgiixa/UAp+ChJApEfc3j81Gwq3hrppD1jCY5HqCtGCCVdDoW0kw0rW0e E96E8aipUxJ5QKQ3cvAWsDw4MvShXirwfsphtHzorEORoMZGOl3APho0jslgWEGfemzLHI0G66uY TgvNBwYOjQefa/2Sf/off6b3BgaTkIH3vt4LAAAAAElFTkSuQmCC and zero otherwise. Assume again that Bank Alpha and Bank Beta are correlated, with the measure of correlation between the two banks still being 40%. Note that Project IV is riskier than Project I since it has a higher standard deviation (indeed, Project IV has a standard deviation of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAB4AAAAQCAIAAACOWFiFAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAARNJREFUOE/tlLERwjAMRZ3MAhQ5JiATwCBJyQKUDBBK6GipaCAbZIJcCpxd hCXbkhXSpsOVT9J/tr90zgDALLPyZbBIXRo9XsosrLrlZ7T1TJCzrCkvYwwmHIwCvCtjqrfzPN26 YIjZZsd5KlKFmN01VouBNAbJIafYTNEFTGZN1CMu3AaIPfF6XeBx6WrrQ9/cj6s0Nn56VdMN1pjV ZmtuT+/n+Hp0VW4crXu82C/ReOcOt/kZ2m7CaXyb/RVscab+rIcTXJ3XwZlIEHf842e8Tgz2eTIi cZYKEC3LhaZkrZEu/nitekb3UVxpqEyITNDcKMkD1Ouw1KNpJ/1lH7xJ8YIJOkq0ymOiJvv/IXpM F/yevsu+n+R8htROAAAAAElFTkSuQmCC , while Project I has a standard deviation of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAA4AAAAQCAIAAACp9tltAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAJpJREFUKFPNUsEVgCAI1WZpCttHjy3QELaMLtIp24VAUfFmt/4J5MP/8NQA oOawzNGI9ZkanWa4OMqUynY++AwQrLIBLQMkb1SNMcWCyACpAlg0PrU2nsAESRVEEjDe49iM3FOo WZkgZzZ1NjIY6F4p6vJFbjjWuh9WXTdti2hBvYm8gNiZxlY3vAMZaE671/G1WNH/+ANT3+sFGYbY Eb4xHhIAAAAASUVORK5CYIJ= ). However, Project IV has a higher net present value than Project I: i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAKkAAAAQCAIAAADicsjFAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA9VJREFUaEPtWT168jAMNj0L6cDDCegJoEsnVrYwkqUbI1uXMMLGysRScoLm BDwMDXfJJ1m2k9gKsSnPN9BmSUhs6dWrH0ttryxL8Xf9SgaefqXVf0YjA/f3/WX90pPXPCOKs7l+ +iHl2ZwEv6wvt0m6G5Lb1N+RCj8AXfZCzVfXMUaJo7RQv4t0RCrcV/HR7MJVtZ9lCS+qDSTTkoJ7 8YO9Ta+0pDd3w8ZKfAW+88kfCVrgQmZfdmqtLQgAIHc5xIYoI4Id5o0R0qkq7zGlDm8o/WvRV9ka JUN0cZGKZCYz7bKe7acQGUV6WunUyz5g1WbMx2E2n4gjoABngpT9p0xXqgurk+JX1walDUFvJ6pQ ZHMHg1/AO6v8kUCZYpT+GEkAAAkeuE7yG42Fbaw6YwQ5NRItEVZPL/0Md0pJ96EWk1Xeqyfpe/tq RnUjmU1J4DCg7vC890fSkG90sUhC8jAAAOV8nBaG5boiP/NZdQ3K8Qfk/eVzL9LBgc5SdUpfvk+N oMvPhRuEl/XqlL635Dws7y+WwyTqTbZh8RsNqCR4YfAT7Y+EVXoNiW5CFH36ZvUk/gBk0s7Euyq/ tn3jTbkTs662h1XXfx6K7YGaMPB5Hj/JW56cZcGvF1wxfKbqL7Qz4C73AhWjQSSw3C8XQrV2bD8H SPHc2k46+jOQnKsjoWmsg8HP1+4qXyS4k1XahgQFM5c+Og0SbwDZfDXYVZ53+7X+4ksq1DHgzTxA KAYrGTfReVlu6LyP9ZE9fovF6ZvaaH038CGa4CyGjejzAs/yTcS0ABbxEG7xsZjuoyvdfn+xwwOI kiZKcgwtHgPje7/MwzrkgYQ1vPVlYCR6AIBaus2JCaiXwPbkpLmwlekYeIOSzY4+tjogaiZ21EhC DLyQ7103Q30wV3HWztBBDj6ncg+fZEKAGvZY0DL6r9ORo6RujDaE5oTpK8nkMDh8+2YebexAwiq9 hsQ78vyoqHjQXZVTQQwBaprGHr19UWVvdtgSsYqF/EmSYQqu+Q4FIE8+8HDASDR7SK9s+Gt1qSX8 gRaT6zpIOjIFzImM6KsYglIuAAmr9AoSv8gLANBtmA43lcTMlMWqw4OVXAoX+ENgn18NtI2Z20yI dptea0B1U18b6puPxpJKSG3IhK/mPamzdLkY/BpdbqzQUDyRWGBa2fBr9+tGdwJQsxQCtmca5+8i vHpenTX0S98HXRb5ipPG33+agNkZL0hl+JDDi78vkhtM+M8AOtSF+77LZBNyzFTftff6d5164fP9 z/Q+6u4eGNZ9wvyteEQG7v+/nEdk6TFt+gfzBX/gtg38WQAAAABJRU5ErkJggk== . (These features of Project IV—higher risk and higher present value than Project I—can be generalized by requiring that the probability of the medium state is reduced by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAFQAAAAQCAIAAAAHwM/sAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAhZJREFUWEflVj12wjAMVnoW6NDHCcIJeFmYWLs5Iyy9QbcsyRiOwMTS5ARw Ah5Dk7tQyXYckx9b4dEJLfmx/Pn7JEt2cLvd4HWszpYJbACifDsDeHsd4aR0tj3lkZFsiceoBMus dkWjjIMgLskRHwDm5VkRHMNX/5+1SouD2x6tSkMI00p9jFshpBN6iwK9CiEfD1shNI9maRc+OjMY +riQUDIJBVo6C7cRrVRXaeqUjmxdsSHlapwIyTcPPg6zaPoCYMZp29c/B9hE2AB8Vl0X65Vyuhzj BCL94Zs3MF5n33tR5A1A+DFHJw/+LNrALuHsfkYFS05W4NuINfuRAm0SaJUGKwfOzLeDZgcw8L3r auLMDTIgngDU7CoVQqjyfsBc4lUBywKcAm8KpEunydYUMFnzHUSrsYyu5eyJg0Vwnwsrg5P62CCh tnl4M9Sh1jvny+M+1A2AekH6NbGuV3lD4S7zJ7pUGKuu58W7+jH/CM/Xit81VHewjVZcHwMy33HY iQ6Kxz4SXn5753sZfx5ojTrLOD2GTx+AAqw1lMnu3NczAobZMEHrBwCV6Rh4g9BMvjtr6MMqH/nK bB79LTda87TpsZdoBvwy9bY7w6FtW85KkOf8YMf3FpDPYVS8vsr45nfG+dLZwFp8k/KH08xe0LrK 8OcwM8kHVJ6W+KlTH/T/hwzymZgLtSy2gALwclbGMeT56g845U+V27kY+QAAAABJRU5ErkJggk== , the probability of the high state is increased by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABIAAAAQCAIAAACUZLgLAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAMNJREFUOE/Nk7ERgzAMReXMwlExAZkgl4YN0snDpLHLrJAqlVmES4G9iyJZ JBcKDKSKGn9sP+t/A4aIYH8d9iNCrGC9Ncb2yR9lAPgIYJOFCti6SBRdi4G3BcwDUblbGoemrgCq umFnyY/d7ZRTlbH4bDrdB8PDXuE8PcBkMqAuiiXWaoWt5QmVk9JEggmjk9EhosYoF2NMvU+S8zdA 0m1Ozawsd/y6kt5e7pIvec+vaKU0mhS7y3JLQ/NP3+RSwh//gBf0kCjWtOAiOAAAAABJRU5ErkJg gk== , and the probability of the low state is increased by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABEAAAAQCAIAAAB/UwMIAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAOtJREFUOE+dUzEWgjAM/XAWYPBxgnoCdeEUZfUQbiww6hGcXIQbcAIeA+Uu NU1bZfBRMUuTND/5v3mNtNbYaPHGelO+hunKKCq7udmbA3g7IG7OWulmilpxqpXsqVrIlkM+tPZz qOcRnFI1zhW1xTwNeZYASZabqJmK64G7WszcXG6ydSlA7FJKqjEvbBGGR1nh5AJYbkTLzTUE2SVG cCTJ9XS5mjFUSElT5aEflV88g1n0sehVhH0DNfYslizdiX5UoZ15Zl7XD3PAzKQkKWzuKQJ63OYC GpbXsd9cSMPiPn7ewRvcYNEff+EFEDVXlBQCnukAAAAASUVORK5CYIJ= , such that data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAKsAAAAQCAIAAADmhxj4AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA6JJREFUaEPtWD124jAQFnsWSOHHCZwTsDRUtHR2CU06ynQ0pgxd2lQ0a58g nMDPBfZd2NGP9WdZlmQ272WJG8CWZr5vZvTNmMntdkM/1wNH4NcDc/+hjiMwUAFFOpmkRXN8xh8I 8S8iePjW87H5omhSPHd3NkwTXH4V03/EERgYaSLoApYrT+Ksvt3qLE5yWJYn5KO94DYiz8mVJyQz 9AZ+hC9lvd1X+5TZkXdSa8wVPBdO3Uxqq5gHbhGg22gyOh2mvQj9QClxE7EcyZGmQA2/kaa9AtrM 09TXWablX0WpFkQXgGtg6ixJkljYVvKPjcCN8PjggNPAcIRWmiZ/gwhdqZJ1atzY1lEcxYHUqpT+ VLJp7wJ1NV8tqOaW5/SAluwHvtH8+UDr5VRS5Lq6xOIO/ErazX6yXVcoisSW4lCtIeWSr+lyjXaH oGbQHF9PSf7W8oijGTiy0exhOoDQjzCIkRpJ2D6CI3FenMssz+LTWYTJTJNVAO4Q+MIdHb7TVouj VV5Ji59FqIxetlK+oQAu8ye5AJpricSd4nyi4fW+miuKlk/zS1UTJulrtEKaLwhPzJB5mhd1WaSz 3XwPlKw0aQF0mA4i9IDVtU82Gzi2WaK54pdpDCvOaL9dQJh4CfTSZA287d5Yf516d0fk287PuQcK NZVkJoIgtzBWdDt/aIuhlghUJ5ZKs5DGn2GE7n0AMBmxhHKkfUVrdP1wQAPwac3e2fkuT2jPNdKj kLGUXqScAy1VIchx1opX6I7SS3jnqY+barWdYoAdldSxORkHmcKWptvPW45+h77CSGraj9AJD5Xr ULHsTQ+oCoshFhK5EZi2yAfMZ/rQK1Q9p311PXwy2LxK3yxIIZvOgg9SyacEy/2EdZnSSrcjHGZK V8hM+NHtPKFr+TuMmkhdbBUzYvDtQSRNgkW6+aDt/+gwZGlt6l5DAJwIqh2zCOb9F5jYcJvUJ4qe 1jmkWdJxKw67jtWe7RpTN4RDUPhzkM5WLAETlz/T+IEWb8YsfsrzGYiKYmaxSpB9ZBKVBQeOFJlr /5bORluc7csG4edqRz2jeKfUFo3/KwQqAN4GYw4LvvMcoKhQ988KI0JHBdBnJylkgRzNQmFLxcA/ QnYm7krqGBGnZSNiE1CUXKvdR0cnFoORDcbq6X5UBbS96avA0gIP9aZ2Wc84sS4c6tvH2xiOPn7Y 2gl8Ovesb70Q/tbfoHetZ35rRvcB/zgVcJ94/X9W/gIKDXPlck6M/wAAAABJRU5ErkJggk== is positive.) Hence, for Bank Alpha the substitution of Project IV for Project I is always a good decision since Project IV increases the firm’s overall value: i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAKYAAAAQCAIAAAATeZNIAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA1lJREFUaEPtWT1y8jAQNTmLTcFwAnMCSJOKNp0pofk6Sro0poSOloom9gni EzAUse/Ct/JKsn4WLNswEwZUxMayVvve25W0Tu98Pnuv9kwMvD0T2BdWxsDtJS/Wo17ZZilSnM7E XUfK0xkaHq2Ljpa6Dv/bGOsIh4WdtyRiTIRxzn/ncYjU2I+iRI5ibyk/z2d4UA1Am4YVNpZ1mMPE m4Z1fTQMrMxXztfeSTTavPfDaAEsIWO7ChDJaYWR80oSjpQzMT3kinawdI2xgg4IMVVRYaCmnCY5 diYR/KnGIMthqEWKMj91W/nQkg5n+zfAeAkg56ns5vfSLQVgF8lJwk19meRWohqziqCT8to3SpJp 4rJYKSU3mz6nFtaSB/WpvG+VAe72b4aRIhVJqHpIgB0k59SbhBuuwF5efO+9eHDAfZLvwMXvUdvv slNu73/FenWM/40vboz+fDlcBL3JttnWGQxwQ3HyoZnp8u1G9u+AMT9l4SBoBlAcY7hI4mKcamjC TX3fmOJZtjh98AV+OxGHrWHfR0IFR3DdHuBMBlown9OvxXA59/hpjTyijTdlUG8nNUcusJztv4lD meVDC4kRgaP9+2HknqeziZf8zDm1niNARiTRKjvcOkG4pS+e2KNkg8k6/oi84y9yL66SZQiiCNTr BUzqnLm+Cdaf+yns83l8XF04R/v9YZTk031w5dzuz3exBwtC2YIFzwLKB0Jyhwxwt38/jOXCtR6t Bjnnmia5XUyrowjCNX1Rclvd/rCyIlciTwQbSI1rOnSVcQrTkGu/MOK/T0NrEs3P+U9VKITTd7RJ +WBx4pQBvrP9u2EEvT+9nZKYrgABsUNY67zohGvUv3msU6566WGLfEO6Z4svVlnDbsafSaMFy+2d XJwuBSb4KTNbxEZNEAMtgTR91Yd22eBu/9YYwd5pyfUu1rNySXQH6BTWLDBswi19yyKNrlllHWke uJXCjKhplBJOsauUcupTpUbF6Yy5bB9andhFneJgn681XTASAPVHyqcOkuTWGGnCDX15XV77JaN6 wfCH+6x9rtG/I5BFWoMJ9Vdb09FkxsfGWEN4c8nrqJORRlTjdWOv94uMaPtlqtvs6uiHxtgDJO22 xdeoB2Xg9v9WeVAinsft/8NvGc/gVsx3AAAAAElFTkSuQmCC . And, yet, this substitution is inefficient in terms of aggregate wealth since the expected cost Bank Beta bears when Bank Alpha undertakes Project IV exceeds the expected gain of Bank Alpha: i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAALEAAAAQCAIAAADWCwnZAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA8hJREFUaEPtWb126jAMTvospAOHJ6BPULp0YmVLRli6dWTrEsaysTKxlDxB 8wQchibvwpX/ZVskTij33NvioYAjS5/kz5KcxqfTKbqNWwRQBO5u0bhFwInA1ThRrx7ih1X93we8 yOI4Kzw3ioyY/JvOXhMA1A45qnwcpXv7N/dynFdIhM0gMXcVk2RzehH7IYezrJ9yA7D12z6l4Xf1 CPSYGJxOQq2Dns/i8IkwuFL0ZKsntgANAGR8DEbUxtZkMcKMwE5p9WaD4RsPjfpkS0HMNYYfY5QI cH/lwdGjw8OxdvbIcll4vE/hj/RU7P14bB8pwke0adaxCXaKC/oApE8eBrM5HGIoKyQnqjzNK7y/ +Gio7/q5/wV55VLCnDAdpf7KA6NHJa/LjGqN0j3OCWs4NilzbDt1OJzkE+iZpqcPQDKD3nk3Ik3W eT9RZLPoZT5A5bD+OljFsTxWfrGsV8tD/vJoP6g/tuXoHuvSz5OhyKX9lQcWbMAQ5cNdLIYo/Bca HTxNx4cvaI8G89fRIokn62YspLkWDKx1IYbTlQUCcOBVx3I8TMzk4/tpE824Na/rA04U2XK4MYzQ zYveWbWX8LneQYDBNaa/eFuMXucR9JIm8m6gYEm5/SA6ze9Qfm5XGC3LxfFZZtr1RLWDFxqVBwPC yarGetLWQ3vmGGByUnjCFBPj0zqtUi4IgA5QkU2ivatnMP/k1hQ3dNN8B4d9XQLxYQD3wdHJQfKJ Hws8gKEpCMQJ40LFzLwnq9l2yluMw5K6ZAzmmzwS2tk6w9XeysMOE9TOd5HAHp/TSBnrbdRj3+B+ lO6r6TZpun145pgacjIw/yGxIABCHm6Ay2Elw0FYUtx4hsTKc8admjH9IuMTmDSrTd5RTAYuiLIB jzjxQZ4sLyzXCjaKQjh9EsL9lQceJn/7LzEq4FrJF37rekIFmjJ3xnG1PJDuxloTACkFhJhFGy/V WIjZawMYO0isXPDc+wk4XuXijVVilkjEXupRs+yAyo2VTFThtQMFdhO9prfysPPEQqUrVrGT6C8z qtsk2DidG9SJoGCR5hoxBNaOUAAiRcyOr5IQ9SpzMrniIJCGnVmTSXQBkzdZ+5rAvXU7WXQ/oa6n RIvrK9H35o7KA9tz+qVIf6PoMoVUq8jgKRQu0txZDIGeodceVlQJDPYUfs9Evckw9vX7iWBIzi3G o1LjlajNSoDyNhXdn7cata7XQj95Fexuuv+KKwLozolANxhX8Mu/wGX/nNhP8aNDYGOQDavSN6nf EoGr/Q/stwTwB/r5B/twStr/vpxVAAAAAElFTkSuQmCCdata:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAA0AAAAQCAIAAABCwWJuAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAALVJREFUKFO1krERwyAMRSGz+FJlAq2Q3iPAOtQZIVUawwaeIJciZBciCZBR E7uJCs6I9/0/OmwpxRyo0wGGEOGS9+mXBn1LdEJAyNSRqkcQDFMu4opLDjCAxGCTy/Qz5oZCiUDM ia3i+M+h53GROCqSU46Wrm6bkjN2K/LdvLQrgmp+03WG5/vTLr998fyStzK5/Fov5wnbpFjvS5Wk xw3Qt2apNdxlaGNX5VMT1hv7r3ew826+c6jrbB9UCnwAAAAASUVORK5CYIJ= . (This result can be generalized under the following condition: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAK0AAAAQCAIAAADrmWi/AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABARJREFUaEPtWD12ozAQHvYsOAXPJyAnsN1QpU2HS7tJ5zKdGyjXndutaNac IDmBn4vgu7Az+kESCCFwsrvvxWosC2n0zcw3M5KCuq7h3r69BX58ewvcDUAWcPGgXAfBurzmj/QD 0HRwGetTow/uRlMf8+vQtNu+c6i3yehZ/S/wkzrUPt9uvT7FuiDaKRWWiLOKDZ1S1quyOD2xv+yH NRyTs5SAbg+ngZonNuAD9ImakukS1P5miFL4fTCN2caKX0fMtRi/rQ9+nDNesKkdwTMN3OdT0EjA VzRrpf85Aaosa1jgyYMOWUyzdkGOcJEpapidaNTRjLPgT9NUC4CpLBBW7njZ3PB2HnC2tXjL/7Z9 yuvCNX89pKefC5kQohn2qss8ESPnYr2HlfzsmX6vv3/B0yrUZleX91iN4L9UbuAp0pimiRLj4eoJ tvvPKg82/BBFCkO5vzxhXjR19NdkEn7M697FoizO2SmLD4WySK9POQ+US8r1bDvfbUJGjfMHK+uz CM7RC471Nyqioj4jUtZDM77PH/RF148zqJGyOMSMb1NaVziTgkSIBWh/qaIYC/iNJjb8EK0e5u+X ioSX69cogbaOnttOxr/4WR/h2evwUBaw2yzQIg0RHD5lPOAuYWe/IqlrlhfCzVv9xn2PXdHr1VIj Uq97SXc4LPkJKAiWh8mRpBO3A0m4ydMhOA1Ni2kSFH96shTlh4dwFjGmXfMiOm4AE9wkLjty4SB+ 8gw1yQf7+Rh9DpRtKTQkERw+JR5gnJJLaNYJlt5pR7M0SeD2ELJsXqCqIE6grEBpuUFMl8dkSRXx 20Xkm0uUwOVBo2BXIHqXY0BnN9WwpYSWU6v8+ZJsQoLRqgp+Kvjid5JZ8iEpLBcLpYdOhH55xAN0 kEzXaI9BPnaFqUrak+9k0lFGQ0t0w44i09I6yUgnG2YxMyD0AFUCjXNif3bDkr9rjkmmolhtieoh Fobtks0y6xyf7aWCN353UhOXd0rhbY10OiNi0M8IVqHIA42c5X47JdFJItHhgtaXOb4XtGr1Jx4O dOIiYi1+HTR0m5RsBVX+WCQNC1r40Uo8WDBU4uwFMy5tNrkqyMCbgl/mnGc4UtRYeGtKXSR61esx BHsKwNuQ+Ox5uTJuOFWGlylaj4vZVUUI0S6G8m1CXlrYbtNux/LhQeqjSXG8agzdGwlgG08Xv2ad ye8f3vit90bCOeij5iVI8/mAsUG+Fo24u7ffkfQHpqF3jHHbjJrtfNsa4oF9p5ueOEaBb9uUn6Cm RcrYjWk+NK9Fo1Y3pOYpwMVQW6SN2stn8hdu8oWilWatTWRA/z0eBFgV4Dh0LXQVVzytzC47W5Vy l+T71//JAgHlhHv79hb4A6xwwLBY1fwnAAAAAElFTkSuQmCC , which entails data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAHsAAAAQCAIAAAC5lpexAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAsRJREFUWEflWD1y6jAQFpwFU3h8AuUEIQ3Va5l5hShJk1OksUsy8wpaKjex TwAn8LiwfRe/Xf1ZJlgY2TAk2cbC7O/nXWlXpP4+VIaUALEwpOwfrmlYovcJIyxph5Ew/SZhmu2U y5QBCSBQU4aMUkPaJuSC3RRj+BZURe9kh/iSPdlt/24OdX3YzND15229fe6KoSqy46s3AVpkvie4 0jX+lvQUVfCqKvzlEp9gxQ+I4rwBMjbE0bF1WkVP+EBn5OIGblxWWX3uyRwATuPszwsH2kaeTwoE kpAyD3j+Q4EEKC8/UZOd4rOVhHieny1W5O2FZJqzKsYHvzENxSlIViFUK1+Br7yyjEp1qaahMtI9 SpvtxKZSeIsbEQ8Cpbv3B/Pf9nrsPaWuifS6sYNOcjsKaQF1GYYne+VQCG8tDyGp3HExpXFwEbbI CMRN7bAWjuqchlyHQ0WcUl9pYGAjx/P46gTizWmvc13XI/8e9mSRTcSglHp8qEbykCMu0pTjNmjf UsgPUjJSYA+rBhE3cnicLQILpV0Vl3qLX/G/SALsDsv8qNohz6fHHDolR+IN5GQSL3WvLBU9bMbd 0zGBBSCexh9Udvzp++tRra8BXY0UKz6jWOaRa5T+PF4+4Exh2spokK/4BLb4YIkc5HrHi2owqZGu le1t5CcxqjnnnuWlbCVhV8vZw5t+A4KLiS+aXZTw8/HcCEP0nNMjyDFZ7ENgL0uXjnl3E4ZmdyW6 CWwHM4Xrihte23TuBmnhl2K/F7c3F69tkE1cOukLHrjB2pFPENWURoKDU2MCbUjZLua2o43mtp8n DnREpyLid2wnHsLJuTncafOtojXCka7R7TTO1bUSNpJvAP1sHrCk+w4QRgUWYBsFt3t7GBsE52ye xybkJqDKBDRQsR8GlqOAt1gcTVjh19eaW36ec+C8VhGRocdg+w9zgA+NS0gYpgAAAABJRU5ErkJg gk== ) Thus, in contrast to the conventional scholarly assumption that risk taking in the banking sector matters mainly when it is excessive, 74 See, e.g., Lucian A. Bebchuk & Holger Spamann, Regulating Bankers’ Pay, 98 Geo. L.J. 247, 255 (2010) (limiting the analysis of the problem of managerial risk taking in banks to the undertaking of “actions . . . whose expected effect on the bank’s value is negative”). this simple example shows that any ex post increase in bank asset risk—even when individually efficient—may potentially lead to social losses. The likelihood that this will occur depends on the level of interbank correlation.

C. Modern Liquidity Production

In recent decades, the growth and deepening of the securities market, the liberalization of banks’ investment services, and the steady progress of financial technologies have combined to produce major changes in banking. 75 See generally Charles K. Whitehead, Reframing Financial Regulation, 90 B.U. L. Rev. 1 (2010) (discussing the changes that have intervened in financial markets and the banking sector since the 1970s and arguing that these changes create the need to reform current financial regulation of financial intermediaries). The traditional banking model, in which banks use deposits to fund loans that they hold until repayment, has been increasingly supplemented by a new “originate and distribute” model. 76 See, e.g., Brunnermeier, supra note 67, at 78. Under this new model, banks no longer hold loans on their balance sheets. Instead, they distribute them to investors, including other banks, through securitization transactions and other financing arrangements that can transform illiquid assets into marketable securities. 77 See Strahan, supra note 29, at 17. Loan sales and loan syndication are additional methods that banks use to distribute loans, which exploded in the 1980s with the development of new credit enhancement techniques. See id. at 22–23.

In a stylized representation, the typical securitization transaction begins with the issuance of commercial loans—most often mortgages—by an originator or “downstream bank,” which basically acts as a seller of loans. In the second step, loans are pooled into a large portfolio, which is then transferred, in full or in part, to an “upstream bank” that acts as a buyer of loans. The third step is the actual securitization of the loans—through a special purpose vehicle the upstream bank issues asset-backed securities to end investors, using the portfolio’s cash flows to repay capital and interest to the investors. 78 See Gary B. Gorton & Nicholas S. Souleles, Special Purpose Vehicles and Securitization, in The Risks of Financial Institutions 560–61 (Mark Carey & René M. Stulz eds., 2006) (providing an overview of the mechanics of securitization). The asset-backed securities generated by the pool of loans are organized into senior and junior tranches having different priority of payment and different ratings. See Martin F. Hellwig, Systemic Risk in the Financial Sector: An Analysis of the Subprime-Mortgage Financial Crisis, 157 De Economist 129, 139 (2009) (Neth.). This guarantees that senior tranches will be negatively affected by portfolio losses only where the “cushion” provided by the junior tranches is not enough to fully absorb these losses. In exchange, the interest portion paid on junior tranches virtually absorbs all the residual cash flows that the loan portfolio generates. See id.

The growth of securitization has been a primary factor behind the transition to a market-integrated liquidity model where banks of all types—including both investment and commercial (i.e., universal) banks 79 See Gary Gorton & Andrew Metrick, Securitized Banking and the Run on Repo, 104 J. Fin. Econ. 425, 425 (2012) (“Securitized-banking activities were central to the operations of firms formerly known as investment banks (e.g. Bear Stearns, Lehman Brothers, Morgan Stanley, and Merrill Lynch), but they also play a role at commercial banks . . . such as Citigroup, J.P. Morgan, and Bank of America.”). Given their traditional involvement in the issuance of loans, commercial banks (and commercial subsidiaries of universal banks) typically served as downstream banks in the securitization process. Stand-alone investment banks (and investment subsidiaries of universal banks) acted both as upstream banks and end investors in this process. And universal banks were involved in all stages of securitization transactions through their commercial and investment subsidiaries. —jointly produce liquidity through a chain of interconnected bank obligations. 80By granting access to a larger liquidity platform, the “originate and distribute” model has indeed provided more and cheaper capital to all economic actors. See Margaret M. Blair, Financial Innovation, Leverage, Bubbles and the Distribution of Income, 30 Rev. Banking & Fin. L. 225, 242 (2010) (“[T]his process made a virtual avalanche of credit available to individuals and businesses.”). Political and monetary choices also contributed to the rapid expansion of the liquidity platform. The Federal Reserve’s long-standing policy of low interest rates and government policies that were designed to foster affordable housing helped U.S. banks to offer increasingly cheaper mortgages to their borrowers, with more and more people running to get a piece of the action. See Charles W. Calomiris, Financial Innovation, Regulation, and Reform, 29 Cato J. 65, 67–69 (2009); see also Stiglitz, supra note 1, at 315 n.1 (stating that according to the U.S. Census Bureau over four million Americans became homeowners during the housing rush). As aptly observed by Margaret Blair, however, an excessive supply of liquidity through increased leverage of the banking system might be counterproductive by leading to the exponential growth of systemic risk. See Blair, supra, at 225. Before the crisis, this model was touted as a way to improve the efficiency of capital allocation through more and better diversification. 81 Cf. Martin Hellwig, Banks, Markets, and the Allocation of Risks in an Economy, 154 J. Institutional & Theoretical Econ. 328, 330 (1998) (Ger.) (“[A]bstract allocation theory provides the general principle that efficient risk-sharing requires a subdivision of all risks among the agents in the economy according to their respective degrees of risk tolerance.”). Pooling and tranching theoretically provide for larger risk sharing among investors. As compared to a single loan, a security that is backed by a pool of loans diversifies the risk of default across the different loans in the pool. And the issue of multiple tranches of asset-backed securities with different priority amplifies this effect by making the holders of senior tranches virtually immune from the default risk of the underlying loans. See Hellwig, supra note 78, at 141–42. But the practice of securitization turned out to be different from the theory, largely due to fundamental flaws in its assumptions.

First, securitization models vastly underestimated the risk of moral hazard. Within the multiple vertical chains of buyers and sellers of securitized loans, each bank has intrinsic incentives to take risks. With each securitization transaction, the seller can externalize the cost of its own risk taking to the buyer, which, in turn, will act as seller in another transaction, replicating the same moral hazard scheme. As a result of this scheme, banks were insensitive to the quality of securitized assets. 82 See, e.g., Benjamin J. Keys et al., Financial Regulation and Securitization: Evidence from Subprime Loans, 56 J. Monetary Econ. 700 (2009) (providing empirical evidence that securitization transactions produced lower credit quality). Instead, they focused on increasing securitization volumes. 83 See Hellwig, supra note 78, at 143, 166. Perversely, the expansion of lending to riskier borrowers and the securitization of riskier loan portfolios became rational investment strategies for banks. 84In principle, similar distortions in risk incentives can be mitigated by structuring the operation as an agency securitization, where the downstream bank (i.e., the seller) retains the equity tranches of the securitization operation. Indeed, the downstream bank should have incentives to select portfolios of better quality when it stands first in line to bear potential losses. Günter Franke & Jan Pieter Krahnen, Default Risk Sharing Between Banks and Markets: The Contribution of Collateralized Debt Obligations, in The Risks of Financial Institutions, supra note 78, at 603, 603–04, 606–07 (arguing that the originating bank’s retention of the “first-loss position” reduces asymmetric information and moral hazard problems affecting loan trading). In practice, however, most securitization operations took the form of principal securitizations, with equity tranches sold to outside investors. See Hellwig, supra note 78, at 145 (“Originating institutions did not, in general, hold the equity tranches of the portfolios that they generated; indeed, as time went on, ever greater portions of equity tranches were sold to outside investors.”).

Second, while end investors were not passing risk to someone else, many among them turned out to be other banks rather than investors with a long investment horizon (e.g., pension and insurance funds), as predicted by the theory of securitization. 85 See Hellwig, supra note 78, at 140 (explaining that at a theoretical level securitization should have shifted the funding liquidity risk inherent in the traditional banking model from originators exposed to asset mismatch (i.e., high funding liquidity risk) to investors who have “long investment horizons and therefore do not consider [this risk] to be a risk at all”). And as competition for securitization operations became more acute, banks involved in the securitization market began to take recourse to less costly short-term financing. 86 Cf. Brunnermeier, supra note 67, at 79–80 (suggesting that banks’ recourse to shorter maturity liabilities was a factor leading to the crisis). The need for less investor monitoring explains the lower cost of short-term debt financing. Indeed, short-term investors can price increases in risk in subsequent loans or, more drastically, refuse a new loan when unwilling to bear increased risk. See Mark J. Flannery, Paper, Debt Maturity and the Deadweight Cost of Leverage: Optimally Financing Banking Firms, 84 Am. Econ. Rev. 320, 321–22 (1994). In particular, investment banks began to rely heavily on repurchase agreements (repos) to better face the competitive pressure of universal banks, which enjoyed the comparative advantage of access to deposit funding. 87 See Peter Hördahl & Michael R. King, Special Feature, Developments in Repo Markets During the Financial Turmoil, BIS Q. Rev. (Switz.), Dec. 2008, at 37, 45 (observing that U.S. investment banks largely dominated the repo market and used repos to finance about half of their assets). Under a repo agreement, one party (e.g., the investment bank) sells securities to another party (e.g., the repo holder) and promises to buy the securities back at a higher price in the short run, in practice using the securities for collateralized borrowing. For an excellent discussion of the many implications of repo financing and its consequences during the crisis, see Gorton & Metrick, supra note 79. Because of their deposit-like features, repos and other forms of short-term financing allowed the rapid growth of banks’ balance sheets. 88In addition to repos, the use of short-term commercial papers—unsecured obligations that are issued for a fixed amount and bear a fixed interest rate—also added to banks’ leverage capacity, providing an important supplement to deposit funding. See Brunnermeier, supra note 67, at 79. In particular, before the crisis, this form of financing was used to finance operations of the special purpose vehicles employed in securitization transactions, typically with the provision of explicit or implicit guarantees by the sponsoring bank. See id. at 80; Strahan, supra note 29, at 26. But this higher leverage created additional incentives for risk taking. In a perverse spiral, the undertaking of risky securitization investments commanded more and more leverage and, in turn, induced more risk taking. 89 See Blair, supra note 80, at 277–78 (suggesting that higher leverage poses a prisoner’s dilemma: each bank is better off using more leverage, but all of them may become worse off if the banking system as a whole becomes more leveraged, because this will increase the likelihood of systemic risk). Additionally, the use of short-term debt disproportionately increased banks’ exposure to funding liquidity risk and with it the likelihood of sudden requests of withdrawal by short-term creditors. 90In most cases, the settlement of repo agreements was structured to take place overnight, with investment banks rolling over their repo funding on a daily basis. See Report of Anton R. Valukas, Exam’r at 3, In re Lehman Bros. Holdings Inc., 433 B.R. 113 (Bankr. S.D.N.Y. 2010) (No. 08-13555), available at http://jenner.com/lehman/lehman/VOLUME%201.pdf. So banks like Lehman Brothers, for example, “had to borrow tens or hundreds of billions of dollars in [repo] markets each day from counterparties to be able to open for business.” Id. This risk finally materialized during the crisis when short-term creditors began to deny renewal of their positions, causing the failure of several banks. 91 Bear Stearns and Lehman Brothers provide paradigmatic examples of the consequences of the increase in banks’ exposures to funding liquidity risk during the crisis. Both banks had made significant investments in mortgage-backed securities, relying heavily on repurchase agreements to raise the capital for these investments. As a result, when the rate of default on mortgage-backed securities began to increase, both banks suffered huge losses in the investment portfolios they used as collateral to support their funding needs. In response, the banks’ repo creditors required more, and more liquid, collateral. Eventually they denied rollover of existing agreements, essentially playing out a modern version of the classic bank run. See Duffie, supra note 1, at 13–19 (discussing the dynamics underlying the failure of Bear Stearns); Skeel, supra note 1, at 23–28 (discussing the failure of Lehman Brothers).

II. Bank Governance and Risk Taking

The previous Part discussed the economics of risk taking in banks and explained how it may lead to systemic crises. This Part examines the relationship between banks’ corporate governance and risk taking. Corporate governance is the complex set of legal, contractual, and social mechanisms by which corporations are organized and operated. Perhaps more important, corporate governance is understood as “one of the ways of regulating business life” 92 Commission Green Paper on Corporate Governance in Financial Institutions and Remuneration Policies, at 2, COM (2010) 284 final (Feb. 6, 2010) [hereinafter EU Green Paper on Corporate Governance]; see also Jonathan R. Macey, Corporate Governance 2 (2008) (“We care about corporate governance because it affects the real economy.”). not just within individual corporations, but for the economic system as a whole. It is thus unsurprising that in the aftermath of the crisis, weak bank governance emerged as a candidate for blame when commentators pointed to excessive risk taking by reckless bank managers and the harm caused to bank investors. 93This view of the crisis has been equally endorsed by academics, policy analysts, and regulators both in the United States and Europe. See, e.g., Fin. Crisis Inquiry Comm’n, The Financial Crisis Inquiry Report, at xviii (2011) [hereinafter FCIC Final Report] (observing that “dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this crisis”); Hamid Mehran et al., Fed. Reserve Bank of N.Y., Staff Report No. 502, Corporate Governance and Banks: What Have We Learned from the Financial Crisis? (2011) (providing an excellent overview of the governance problems that have emerged from the crisis); Nestor Report, supra note 53 (discussing corporate governance ineffectiveness in six major U.S. investment banks); Stiglitz, supra note 1, at 154 (blaming the crisis on “poor corporate governance”); Kevin Dowd, Moral Hazard and the Financial Crisis, 29 Cato J. 141, 153–54 (2009) (arguing that the failure of corporate governance to control managerial moral hazard in banks was a central theme in the crisis); Grant Kirkpatrick, The Corporate Governance Lessons from the Financial Crisis, Fin. Market Trends, Sept. 25, 2009, at 61, 62 (arguing that failures and weaknesses in corporate governance arrangements played a crucial role in the collapse of major financial institutions during the recent credit crisis); Report of the High-Level Grp. on Fin. Supervision in the EU, at 29 (2009) (concluding that corporate governance was “one of the most important failures of the . . . crisis”).It bears emphasis, however, that the attention to bank corporate governance is a recent scholarly trend. Traditionally, law and economics scholars have focused on the governance of non-financial institutions, paying little attention to the special case of bank governance. See Renée Adams, Governance and the Financial Crisis 5 (European Corporate Governance Inst., Finance Working Paper No. 248/2009, 2009), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1398583. Two notable exceptions to this trend are Jonathan R. Macey & Maureen O’Hara, The Corporate Governance of Banks, Econ. Pol’y Rev., Apr. 2003, at 91, and Renée Adams & Hamid Mehran, Is Corporate Governance Different for Bank Holding Companies, Econ. Pol’y Rev., Apr. 2003, at 123. For an empirical study of bank governance prior to the crisis, see Ross Levine, The Corporate Governance of Banks: A Concise Discussion of Concepts and Evidence (World Bank, Policy Research Working Paper No. 3404, 2004), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=625281. However, while current theoretical frameworks have addressed the effects of governance on risk taking, they have failed to fully consider the relationship between external and internal governance. 94A recent empirical work by Luc Laeven and Ross Levine constitutes an exception to the lack of scholarly attention to the role played by the interaction of external and internal bank governance in leading to the crisis. See Laeven & Levine, supra note 45. However, that work primarily focuses on assessing whether bank risk taking varies with different types of banks ownership structures (i.e., concentrated or diffused ownership), while this Article attempts to provide a general theory of bank governance mechanisms. External governance comes from the oversight and influence that both debtholders and shareholders exercise over the corporation. Internal governance, instead, comprises the institutional arrangements that discipline the corporate decision-making process, such as the board of directors, compensation schemes, and risk management systems. Focusing on the causal relationship between external and internal governance reframes the failure of banks’ governance dynamics. Instead of blaming opportunistic bank managers, Part II addresses the moral hazard of the principals—opportunistic bank debtholders and shareholders.

A theoretical analysis of the interplay between external and internal bank governance suggests that debt discipline would prompt bank shareholders to seek governance arrangements that constrain risk taking. But in the real world, under the protection of safety nets (i.e., deposit insurance and bailouts), bank debtholders become almost insensitive to risk taking and opportunistically avoid monitoring banks. This debtholder opportunism, in turn, points to shareholder opportunism as the immediate cause leading to the failure of bank governance. Without the constraint of debt discipline, bank shareholders, shielded by limited liability, benefitted from apparently weak governance arrangements that incentivized managerial risk taking.

A. External and Internal Governance

The discussion that follows briefly outlines the prevailing theoretical approaches to the governance of risk taking: the policy analysis approach, the debt contract approach, and the optimal compensation contract approach. It then explains why these approaches fail to fully account for the interaction between external and internal governance mechanisms and why a more comprehensive approach is needed.

1. The Policy Analysis Approach

The past three years have seen an upsurge in policy reports identifying flawed compensation schemes, poor risk management, and ineffective board oversight as the salient governance weaknesses underlying the crisis. According to this narrative, captured, and often inexpert, board members 95 See, e.g., Mary L. Schapiro, Chairman, U.S. Sec. & Exch. Comm’n, Address to Transatlantic Corporate Governance Dialogue—2009 Conference (Sept. 17, 2009), available at http://www.sec.gov/news/speech/2009/spch091709mls.htm (“[B]oards of directors did not thoroughly question the decisions of senior management to take on risks. Of equal concern, boards often appeared to misunderstand the gravity of risks taken.”). joined by complacent risk managers 96 See, e.g., FCIC Final Report, supra note 93, at 18 (observing that “[a]t too many financial firms, management brushed aside the growing risks to their firms” mostly aided by complacent chief risk officers). allowed CEOs to gain undisputed dominance over banking organizations. 97 See, e.g., id. at 429 (“Managers of many large and midsize financial institutions in the United States and Europe amassed enormous concentrations of highly correlated housing risk on their balance sheets. In doing so they turned a building housing crisis into a subsequent crisis of failing financial institutions.”); Senior Supervisors Grp., Risk Management Lessons from the Global Banking Crisis of 2008, at 4 (2009) (suggesting that the failure of banks’ risk management can be in large part attributed to the unwillingness of bank managers to follow a more conservative investment approach). This led to a widespread system of excessive short-termism and “rewards for failure,” under which bank managers had everything to gain and nothing to lose as they piled risk after risk onto their portfolios. 98 See Kirkpatrick, supra note 93, at 65–77.

Focused solely on passive boards and impotent risk managers, most of these reports restrict the analysis to internal governance arrangements. True to Berle and Means’s classic vision of the corporation, where opportunistic managers exercise unbridled power over the firm, 99 See Adolf A. Berle, Jr. & Gardiner C. Means, The Modern Corporation and Private Property (1933). Notably, Berle and Means were the first to suggest that the modern public corporation model with dispersed shareholders may place control over the corporate affairs in the hands of self-perpetuating management. See id. at 86–88. policy analysis largely assumes that increased risk taking is a problem of mismanagement. In other words, this perspective treats the failure of bank governance as a direct consequence of the managers’ usurpation of internal control mechanisms to their own benefit. As a result, the policy response developed under this view of the connection between bank governance and the crisis is a closer alignment of manager and shareholder interest. 100 See infra text accompanying notes 207–09 (discussing the U.S. regulators’ subscription to this approach).

2. The Debt Contract Approach

Policy analysis critiques of bank governance are in clear contrast with the classic corporate finance theory of increased risk taking. As discussed above, this approach frames increased risk taking in terms of the conflicting investment expectations of shareholders and debtholders—a problem of shareholder opportunism rather than managerial opportunism. 101 See supra Part I.A.1. Put differently, this paradigm of risk taking assumes that managers are perfect agents of their principals, ignoring any issue of self-interested managerial behavior. 102 See Triantis & Daniels, supra note 4, at 1077 (observing that the literature on the debtholder–shareholder conflict has developed by assuming away the shareholder–manager conflict). To the extent that it considers the manager–shareholder agency problem, this approach describes risk averse managers as a factor that may mitigate the debt–equity conflict. See Macey & O’Hara, supra note 93, at 91, 98 (suggesting that the risk aversion of managers acts as a “risk-reducing factor” in banks as in other corporations).

The direct implication of this abstraction from the shareholder–manager conflict is that the governance of risk taking is reduced to a principal–agent problem between the debtholders and the firm, 103 See John Armour et al., Agency Problems and Legal Strategies, in The Anatomy of Corporate Law 35, 36 (Reinier Kraakman et al. eds., 2d ed. 2009) (describing the agency problem that “involves the conflict between the firm itself—including, particularly, its owners—and the other parties with whom the firm contracts, such as creditors” and observing that “the difficulty lies in assuring that the firm, as agent, does not behave opportunistically”). which is treated as a monolithic entity that makes decisions in the same manner as an entrepreneur. 104 Cf. Timothy F. Malloy, Regulating by Incentives: Myths, Models, and Micromarkets, 80 Tex. L. Rev. 531, 535 (2002) (discussing the currently dominant representation of the corporation as a monolithic entity and suggesting that regulation should instead take into consideration the fact that corporations are not black boxes). Therefore, under this view, the contractual negotiation between the debtholders and the firm is the primary instrument that serves to control risk taking. This reduces the problem of a firm’s risk choices to one of optimal specification of the debt contract; that is, to the negotiation of optimal contractual constraints on the firm’s activity.

3. The Optimal Compensation Contract Approach

The most recent corporate finance scholarship has taken a third path and reintroduced the shareholder–manager agency problem into the analysis of the governance of risk taking. As discussed above, complete alignment of shareholders and managers through equity compensation produces a negative externality for the debtholders: managers are transformed into risk-loving agents. 105 See supra Part I.A.2. In response, the contemporary financial paradigm suggests that managers should be given incentives to act as impartial agents of both the shareholders and the debtholders; to this end, a manager’s payoff schedule should be tied to both the firm’s equity and the firm’s debt. 106The pioneering studies on the use of executive compensation to solve the simultaneous agency problems of effort and risk are John & John, supra note 8, at 954–60, which provides a formal model of optimal compensation design and multiple agency problems, and John et al., supra note 9, at 99–121, which provides a formal model of optimal compensation design in the banking sector. For a more recent treatment of the same approach, see Bebchuck & Spamann, supra note 74, at 253, 283–84, which suggests tying bank executive compensation to a security basket representing “a set percentage of the aggregate value of common shares, preferred shares, and all outstanding bonds.” In other words, under this paradigm, the simultaneous governance problems that arise between a firm’s shareholders and managers, on the one hand, and a firm’s shareholders and debtholders, on the other, become an issue of optimal compensation design.

4. Toward a More Comprehensive Approach

This Article argues that each of these approaches to the governance of risk taking is lacking. Each of the three fails to fully consider that a firm’s internal governance is a function of the richer set of interactions between shareholders and debtholders, that is, external governance.

First, policy analysis focuses exclusively on internal governance arrangements, conceived as a set of requirements imposed by law. But the law grants investors latitude to shape these arrangements. Legal guidance on governance arrangements often comes in the form of default rules, not iron rules. 107 See Acharya & Volpin, supra note 16, at 2 (“[R]ecent literature shows that individual companies can choose governance arrangements beyond what is required by law and regulation . . . .”); Henry Hansmann & Reinier Kraakman, Exit, Voice, and Liability: Legal Dimensions of Organizational Structure 4 (June 2008) (unpublished manuscript), available at http://papers.isnie.org/paper/131.html (“[Legal organizational] forms typically afford[], to the parties forming them, a degree of variation . . . .”); see also Baber & Liang, supra note 4, at 1–2 (“[M]anagers, informed by their understanding of firm-specific governance problems, chose among governance alternatives to construct governance systems. . . . [T]herefore, we observe inter-firm cross-sectional differences in the portfolios of governance procedures and mechanisms that comprise corporate governance systems.”). The thesis of Baber and Liang that managers themselves shape a firm’s internal governance can be reconciled with this Article’s thesis about the governance role of shareholders and debtholders by observing that managers respond to the activism of these investors in choosing specific governance arrangements. For example, each corporation must have a board of directors, but the expertise of board members and the number of meetings is left to the discretion of private actors. And even when internal governance requirements are formulated as mandatory, they may contain loopholes or receive only weak enforcement. 108This is what happened, for example, with independency requirements established by the New York Stock Exchange (NYSE). See N.Y. Stock Exch., Listed Company Manual § 303.A00 (2012), available at http://nysemanual.nyse.com/LCMTools/PlatformViewer.asp?selectednode=chp_1_4&manual=%2Flcm%2Fsections%2Flcm-sections%2F. Before the crisis a large majority of banks’ board members qualified as independent pursuant to these rules. See Nestor Report, supra note 53, at 8. After the crisis, however, several commentators have expressed doubts about the material independence of board members. See Mehran et al., supra note 93, at 11–12 (2011) (“The challenge for supervisors is, irrespective of official independence . . . .”). Thus, by assuming that internal governance arrangements operate in a vacuum and omitting any discussion of external governance, the policy analysis approach is bound to provide an incomplete account of the crisis.

In opposition to this approach, the optimal debt contract approach is indifferent to the internal governance arrangements that discipline the firm’s decision-making process. Indeed, this treatment assumes a context in which the constraints arising from the debt contract are sufficient to adequately control a firm’s risk choices. In reality, however, the debtholder–firm relationship involves changing conditions, contractual incompleteness, 109 See generally Philippe Aghion & Patrick Bolton, An Incomplete Contracts Approach to Financial Contracting, 59 Rev. Econ. Stud. 473 (1992) (Swed.). and managers who are imperfect shareholder agents. 110 See supra text accompanying notes 49–51 (discussing several ways in which managers’ actions may depart from the pursuit of shareholders’ interests). Contracts cannot predict every possible contingency. And managers running the corporate affairs may act in their own self-interest. The debt contract approach fails to account for these dynamics and their impact on a firm’s risk choices.

Finally, the optimal compensation contract approach can be viewed as a partial explanation of the relationship between external and internal governance mechanisms. This approach reflects an understanding of the interaction existing between shareholder and debtholder governance, on the one hand, and a fundamental governance arrangement—manager compensation schemes—on the other. However, it reduces this interaction to a problem of optimal compensation design. Therefore, it fails to take into account issues of contractual incompleteness and, primarily, monitoring, which is, instead, an essential governance component. Conditions may change and compensation schemes may fail to provide managers with the right incentives to act as perfect agents, potentially demanding the undertaking of corrective action by the principals. 111 See Dewatripont & Tirole, supra note 12, at 120 (suggesting that the limited verifiability of the manager’s actions makes the compensation contract insufficient to provide adequate disciplining incentives and requires the provision of additional incentives by means of the “external involvement” of the firm’s investors, i.e., both shareholders and debtholders). For a more detailed discussion of the limits of the optimal compensation approach to bank governance, see infra Part III.C.3. And these incompleteness issues are likely to be compounded when managers are required to act simultaneously as common agents of both shareholders and debtholders. 112In the economics of information, a common agency problem arises when a single agent performs tasks on behalf of multiple principals who have divergent preferences. See B. Douglas Bernheim & Michael D. Whinston, Common Agency, 54 Econometrica 923, 923–24 (1986). Consistent with this paradigm, in the modern corporation managers act as both agent of the shareholders and the debtholders. On the one hand, managers exercise delegated authority over the enterprise on behalf of the shareholders. On the other hand, in this position, they execute the debtholders’ contract with the firm. In my prior work, I have investigated the applicability of the common agency model to the modern corporation at greater length, suggesting that this model provides a better descriptive and normative account of corporate agency problems than the traditional principal–agent paradigm. See Simone M. Sepe, Corporate Agency Problems and Dequity Contracts, 36 J. Corp. L. 113, 124–33 (2010).

The discussion that follows attempts to fully incorporate the interaction between external and internal governance mechanisms into the analysis of the effects of bank governance on risk taking. To this end, this discussion will use insights from contract theory to develop a counterfactual analysis of what bank governance would be absent safety nets. First, it will investigate the general dynamics of the interaction between external and internal governance in corporations. Second, it will apply the results of this investigation to corporations with high leverage, since banks fit into this paradigm. Finally, it will contrast these results with the reality of the distortions introduced in governance mechanisms by deposit insurance and other safety nets.

B. Multi-Dimensional Moral Hazard and the Dynamics of Governance 113The term multi-dimensional moral hazard is used to refer to moral hazard that involves “effort choices and risk choices at the same time.” See Martin F. Hellwig, A Reconsideration of the Jensen-Meckling Model of Outside Finance, 18 J. Fin. Intermediation 495, 496 (2009) (introducing this concept of moral hazard); see also Biais & Casamatta, supra note 38, at 1293.

On a general level, the governance activity of both shareholders and debtholders has two components—monitoring and the exercise of governance levers. Monitoring involves the collection and processing of both prospective (i.e., forward-looking) and retrospective (i.e., backward-looking) information about the firm. 114 See Tirole, supra note 49, at 334–35. The exercise of governance levers consists of the actions investors take—based on the information they gather through their monitoring activity—to protect their investment expectations. Drawing on the insights of Albert Hirschman’s classic taxonomy of the relationships between individuals and organizations, these actions can be aggregated into two broad categories: exit and voice. 115 See Albert O. Hirschman, Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations, and States 3–4 (1970). Exit involves the termination of the investors’ participation in the corporation, while voice involves the exercise of control rights. 116 Id. at 30. Like in Hirschman’s work, in this Article the term voice is used not only to refer to formal powers of decision making, but also to any form of influence (including backroom influence and “jawboning” activities) that shareholders and debtholders may be able to exercise on corporate decisions. In contrast to Hirschman, however, this Article refers to transferability rights, such as sale of stock or other corporate securities, as a form of exit. Although the right to transfer one’s corporate participation to another does not exactly correspond to termination of participation in an organization, what matters for this Article is that transferability rights are a powerful means to influence corporate decisions.

1. The Effort Dimension

As residual corporate claimants, shareholders act simultaneously as the constituency that cares the most about managerial effort 117However, it is important to emphasize that all the firm’s constituencies, including debtholders, benefit to some extent from increased managerial effort, because higher effort increases the likelihood of successful firm performance and the likelihood that the firm will be able to meet its debt obligations. See Triantis & Daniels, supra note 4, at 1078. From this perspective, this section extends the thesis of Triantis and Daniels that exit by a firm’s lenders provides valuable information for disciplining managers’ effort choices, arguing that the interaction between debtholder and shareholder governance produces beneficial effects along the dimension of managers’ risk choices as well. and that faces the most severe contracting challenges while protecting their investment expectations. 118 See Jonathan R. Macey, An Economic Analysis of the Various Rationales for Making Shareholders the Exclusive Beneficiaries of Corporate Fiduciary Duties, 21 Stetson L. Rev. 23, 25, 36 (1991). Indeed, even complex sets of contractual rules cannot completely solve the informational asymmetry problems that shareholders bear while attempting to control daily management actions. Equity-based compensation is useful to mitigate shareholder–manager conflicts, but it faces similar limitations: it is an imperfect instrument to solve problems of contractual incompleteness. First, manager performance is difficult to verify, which may limit the effectiveness of incentive-based compensation. 119 See supra note 111 and accompanying text. Second, while equity-based compensation deters shirking, it is less effective in constraining private benefits extraction. Indeed, the managers’ ability to extract private benefits typically matures over time. Therefore, this form of opportunism may be difficult to prevent through contract at the outset of the shareholder–manager relationship. Further, equity-based compensation may be of little help in constraining entrenchment. Managers’ first concern is preserving their power. 120 See Andrei Shleifer & Robert W. Vishny, Management Entrenchment: The Case of Manager-Specific Investments, 25 J. Fin. Econ. 123, 123–24 (1989) (suggesting that managers may invest in suboptimal projects that require their specific contribution in order to secure their control position). Thus, the appeal of a better return on their equity stake may not be sufficient to prevent them from undertaking suboptimal projects that secure their control position.

In response to these problems, corporate law provides shareholders with a variety of institutional means, including voting rights and fiduciary duties, to exercise influence (i.e., voice) over the corporate decision-making process. 121Shareholders also have the power to remove the board, although commonly removal must be for cause. See Campbell v. Loew’s, Inc., 134 A.2d 852, 858 (Del. Ch. 1957) (establishing that a director may be removed for cause). In addition, under some statutes, they can directly intervene in the governance of the corporation through the amendment of corporate bylaws. See, e.g., Cal. Corp. Code § 211 (West 1990); Del. Code Ann. tit. 8, § 109(a) (West 2006) (amended 2010); N.Y. Bus. Corp. Law § 601(a) (McKinney 2003). Further, shareholder-initiated proposals are possible under Rule 14(a)-8 of federal proxy rules (i.e., the town meeting rule), which gives shareholders voice in several governance subjects, including executive compensation, board organizational rules, and anti-takeover measures. See 17 C.F.R. § 240.14(a)-8 (2011). For a thorough discussion of shareholder voice, see Luca Enriques, Henry Hansmann & Reinier Kraakman, The Basic Governance Structure: The Interests of Shareholders as a Class, in The Anatomy of Corporate Law, supra note 103, at 55, 55–87. In addition, public shareholders have the right to exit from the corporation by transferring (i.e., selling) their shares to other investors. 122 See Armour et al., supra note 103, at 41 & n.26. While transferability of shareholder claims is not provided for in unlisted corporations, buyout agreements and withdrawal rights often grant shareholders of these corporations a contractual right of exit. See id. Because share transfers can impose negative consequences on the corporation, shareholders can successfully interfere with governance arrangements with the mere threat of exit. 123Exit can have a negative impact on share prices, especially when it is exercised by large shareholders. To this extent, exit punishes managers as long as their compensation is equity-based. See Anat R. Admati & Paul Pfleiderer, The “Wall Street Walk” and Shareholder Activism: Exit as a Form of Voice, 22 Rev. Fin. Stud. 2645, 2646 (2009). More drastically, exit in the form of transfer rights “permits the replacement of the current shareholder/principal(s) by a new one that may be more effective in controlling the firm’s management.” See Armour et al., supra note 103, at 41. Hence, “a transfer of control rights, or even the threat of it, can be a highly effective device for disciplining management.” Id. Accordingly, the exercise of shareholder governance involves a fluid process where exit and voice act as complementary means of organizational discipline. 124 See Hansmann & Kraakman, supra note 107, at 3 (arguing that exit, voice, and liability are complementary organizational means, rather than alternative means as suggested by Hirschman).

However, shareholders’ interest in profit maximization does not just involve inducing managers to exert effort. Instead, shareholders also want to minimize costs, including the cost of debt. Under this more complete representation of the shareholders’ optimization problem, shareholder governance emerges as a disciplining mechanism that naturally interacts with debtholder governance.

2. The Risk Dimension

In order to better understand the factors at play in the interaction between shareholder and debtholder governance, it is helpful to start with a simple observation. On the one hand, as residual claimants protected by limited liability, shareholders want high-risk, high-return projects; 125 See supra Part I.A.1. on the other hand, they want to minimize the cost of debt. 126 See John & John, supra note 8, at 951. Instead, debtholders, as fixed claimants, want low-risk projects that preserve asset value. 127 See supra Part I.A.1. These divergent risk preferences are managed through implicit negotiation between shareholders and debtholders. Accordingly, in a world of complete information, shareholders and debtholders would always be able to negotiate for complete contracts that eliminate inefficient risk taking. That is, debtholders would be able to demand interest rates that are fully contingent on the actions taken by the firm. 128 See Alan Schwartz, Incomplete Contracts, in The New Palgrave Dictionary of Economics and the Law 277, 277 (Peter Newman ed., 1998) (“A complete contract prescribes payoff-relevant actions for every possible state of the world and the payoffs for these actions.”).

The following variation of the above example on excessive risk taking will better illustrate the point. 129 See supra Part I.A.1. Bank Alpha may still have the opportunity to substitute Project III for Project I. Under the original setting of the example, the undertaking of Project III will penalize the debtholders if the interest rate (data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAkAAAAhCAIAAACEDBYcAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAItJREFUOE9j/P//PwMOwIRLAig+Koc9cIZ7uDAA08u2NLDf07YB2TCO1YTb /5kmWjNuCPh/e4IVw6wNExEcHTUVBpA+IADJMTCAFCMBqBzIWDSZ//8h4Xnn1hUGqzBvoDHIACx3 Z+uqYwxgGzDlbl87xmClpYoeUyB9IBOxaAO5E+xGiOdQASOd8woAqTFt6bjb6NYAAAAASUVORK5C YIJ= ) they bargain for is based on the assumption that Bank Alpha will undertake Project I: i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAALgAAAAhCAIAAADlOPYbAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABKlJREFUeF7tWjtW6zAQVVhLQsFhBWEFgYaKNl0oSfO6V9LRkBJ3aVOlIVkB XgGHgmQvfhpJlkY/W7blFO+MG/IZja7uXI1GEyZVVTF6iIE2Bq7aDOh7YgAYIKGQDpIYIKEk0URG JBTSQBIDJJQkmsiIhEIaSGKAhJJEExmRUEgDSQyQUJJoIiMSCmkgiQESShJNZERCIQ0kMUBCSaKJ jEgopIEkBi4vlOPzpH7uNmcD8ry5mzwfk0D3NoI5Rp8kjA6Wba1XmQlI6hlh+dlYvbxQgKD5+4n/ H0z19TLtHfPOA4GyJdtW1cei89gMAxYfVbVlS0+n05cvoOL0Ps8wyZguAKULdHVQn+o/eB3Ot+Yr b9hhxVjwQyUU7R4M0YPHWAx2AobXAF7cSc3Cw9+4HGR5HwMilukvb9CcWVllWiQapfDvxUqRKeNm vjVagFcW40GZVJVrJzzygfCX+8WMOZN1AmZRHIaiiUwUikI4KHgyd/gT5hZKdla5UDz+nVg6kbXM cQTsaERZddxphvQAbiCFOASYm07c3VqDrQlNiX4eoYSVklko+Vm9Yuffb76jb2Yo9c9u5qzcfcpK 87gvGLu91tXE4pGnjmKvy049FEZ9/8pB581yzd7/9KoG+GkuyoihwOoFnT93JVs92ligZBilWFG1 uqxL1Ru7iJ0+PM01u2NWFZbvoaxesen1LWPlzykCORAusKwVgYaefkolKCmTbVKpCrSx4n5y9/bj IBgKrHYHuOyNMFZ0oF7eP4qUUew35g3aZjA1LCxOeBZw+Vnltx6ZIl71VRXCXDbAhcxRP/BaZRfI PHLfHt/W5epvkkyANl7284OgLIqSCwbfEIcAy0J3VyewlDpNFTt+w+Jv8GfYn9lpLbOgdoK+R+MX oTv3CKzC9XjxwfdAuZ6p6ZfsCcpZZxuEl8NpOKx4PuDPfbE6AEvH5/qVaRGEF2NcwkEgK1fwpcUy AJjxLVJi0mL8JdpBmvH9I9cabATp4SKFJSbUdi0CN01PvMeQlVXZR1GXeYnn64F5VQteD/CAmDcL AZmcN69aMLP1rSpKy/US99Zi7Ki7D8orQ4CpWcQJlrx/bWh2kPxiNhgkUOb86eGCLaJmteVhNdBw E8WfXmm4Uoic+aiGNSeRONtSz+Tpy1ac8KEW7QBg7Rs3m4VA2Z7B2i0Uon5Hj72cDKz6QoEKg6ES Q5QkKHLuLQhB4kODNSy+D7kB4Tz4neugDvsCE3e4aLGeTSC1o/baWaQc65rZBKLX0TMCq9bx57bT 5Jein4EbbuEGld1Hwe+snB1ry3Aj8Ov17VDj2O1cJgJr6lFk76O0N0SCHbf2YSmdHrvVDXRlYxU6 s/BIiUTa3EorUveRNqbX/LR7tnYv1+vgoi3l+B8MrJZ69JcHM3dLCz2l4dYe8Mt0ZuXuNs9gVmuh dNKrbxzMAwYrjkA4ZWjtDwQSGR6OzjhzNXqNAWkXWD+wKqP0G4xHZfr1GA5S7wpg34eyFwNdHPLb 0+lpN2u7pndx2cOW9wvgJnjRH817wAwPGa61jh5QTkz8Ma7jBA3mY+3bBIQNiVQHJvOvxwmo0k0m 3DSb6MjR/8vAP6GSs5q8yB91AAAAAElFTkSuQmCC , from which data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAANQAAAAhCAIAAAAu4xLlAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABGxJREFUeF7tWj1a4zAQVThLQsHHCcIJAg0VbTpTkmY7SrptkhJ3tFRpSE4Q n4CPguQuXs3YlmVZkmXFkTYwqpJI86On5/HMKKM8zxkNQiAGAhcxjJJNQgAQIPIRD6IhQOSLBj0Z JvIRB6IhQOSLBj0ZJvIRB6IhQOSLBj0ZJvIRB6IhQOSLBj0ZJvIRB6IhQOSLBj0ZJvIRB6IhQOSL Bj0ZJvIRB6IhEJp8h9XNaPS49dvv9nE0ulkd/IR7S4W11tu9HyAQknxAvDl7y/PXmRdy23XKkuen sZdwf6HZa56/sbn/s9Lf5G+T4H8mDTL2yymbLvd6W9bJUkRZA1/FSDaqXnlama2nWmKbhDH1Rxff PBA8kVrZE7sJdwcsK/VTrggzD9x8RHTHinpgAoeRmYU5WUGxOcESVCFzBudLfcpaSQ+INYyafHQ/ JjdkXLfspk27ym7C3QHLSuNUDWMXwmHIhwxoh6fKTZks5tAoFLTIhoyqeaTsubFcJliTbOBE20V0 Z0D2uW/Zm3p2E+4OWFbalPRAGHI+yKz5KMqA8sugef3h4z1jyX0r04Osyin/AwXT5Z9CweH7k1Pt aiIlSJOrKcveP4pSBFJDdn0pUsPZPadmuhZFjhAFqc/vQuiwmi9YZUFNvcZ3D1Oh/ri8zHnL/mbs JtwdsKzsUOKK8AUvAtb3+Gyn61X9RTo8fxgqyf1XprCln87t30VWVxrjy2vGsq+9QYeGm7CyYpkk Cm4V+yyo92asZcCk2WK/zfyC1QKqDoQvnnYi+KTvvBTlkWgs/daEqgyLGCh1Y9B4WZk+rF5SEfbg xyKUvYieC1Ans5wpRLhqwOcyCmLxjOG4SW6Tppq+gfgTBe2j99YD4bLVgrHJ8uiXLkG4tY2dNnZg LPIOpfjKfbiTGyyzVx6ps8Wk5P+cPUDJ4WSBP1ibJL0Fyds02cBLf/tYfcImJA6np+jU5PBD+2j2 HKmgB8IF+YAeygEf6YIsju9J37ihj0oQnMXY3bFWFijbhydLomZ9pkA9iKsVCSeLa+zZbJJsMe9u Zp8nOQY8WJMqV4SRfFgQuASOUz/rrd20Xrm6/aL74tnRp4TNAkVokeqM+i2M7/V2iucC0KAnGxzt Qb0vldkQRvI5FwSezzoWo8YKwbJlCHudERkWyTcfmOJJ1a1a/Ur2uKi2zpDrYPFmaNTXpzgnVacn 2iFcc7ZhRRjId1xO5uAHtCpkOjiI4JLu+zTI0iBjkzs246dnqSCB2MnT2bJN07CMyZ7xuk4KdJq0 03ULZ7UOQ63vxbtupx0I8yazoQPs3eQ0ttztl2CV82JV9+0QFzHdi4j+u3FJ6z6j2ZmXnB2wx1yi rRyUobftewKNm8fSVG3CMqt07y0r7SZKxzsRDnPD4XNLYLyQ8z2Thlzr5qdx1SdfdQxKvUF8Pw8l DggHI19P/gUJx92n+J+40e3oWa4Yca9D5iU8ScOGhtOtWkjH2rZ4BnT7udzre5dxXfsh1kOT74fA RtsYAoF/XeEnraxEEqcAAAAASUVORK5CYIJ= . But in a world of symmetric information, the debtholders would anticipate that the manager could use the proceeds from debt to substitute Project III for Project I. And they would also observe which project Bank Alpha undertakes afterward. Accordingly, as shown in Figure 4 below, they would be able to write a contingent contract under which the interest rate applicable to Project III is: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAALgAAAAhCAIAAADlOPYbAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABL5JREFUeF7tWj124jAQFnsWSLEvJyAnyKZJlZYOytBst2W6NFCGjpYqTcIJ 4hPkpQjcxauRZHn068EW7Hv7xk0wGo9Gnz5rvhkyquta8MUIdCHwo8uAxxkBQICJwjwgIcBEIcHE RkwU5gAJASYKCSY2YqIwB0gIMFFIMLERE4U5QEKAiUKCiY2YKMwBEgJMFBJMbMREYQ6QEGCikGBi IyYKc4CEwOWJsl+MmutmfWyDPK5vRos9KejeRjDH2SeJRwfLdtZrzFRI5jrD8ouhGifKcb3Ae+gt PT9K2cXp6iD/D6b+eBxTrMvYAGQzsa3rl9syDk/zcvtS11sxC3g6fvwAKA6r6Wn+Lm6diNJsZfco WuL8HczR9T4XIvol8q7MwRBd+BkHwcCZA3A4amMBL/6kejA94i2mzG1qOrXMzAL6zF4UVWGpkIwy u4aWC/DJ2YsoTTQpsJ1yL7+AvzIGPJsmiQ1MLTwgkfHl2RIY29IzTqFgb0yEffYMPROnSmmiFEd1 IFEwGVxiJFH1iGIRsg9IA82GgBgeyTxPobnZntgmNME2gFJ2vwxR4mdYYaKUR3W4mJ3+nOisMfk5 FZ/fWp4e17OlWP3upQZkNlcy4vj9KY+axrudotq96Tn2rxshrq+szLm9lyfO5jXQw8e3XSXm924s IBnOIlaMVte61Ny4InZ89zC1i7iY1BiK6nCiVF8HvdrDV2X2TdNkS5KqAJvY/BrdPH95oI2vroWw 3gNEIzwCm4aqrT3E5fLtXLsDevn1Xh0Zm9d1e4PYDFPDwtLrKhJceVRbonw+2TotUsYlRuEUMS8x vOD6vd0/L6v5HxJNADYp+2UiqDabShIGV4j6iHiy9Rfwr8rgCMH80wuW0hxTm52ssOQN/g4HFxI6 ETpqJ9g6Gn+I1dznQDWQ/loV+nKzuQ9HW23dKgv9qS1YsLdA9GIlocBCetWpeaarFZKzobqI6418 9s9rFK9uCLYyroJTK7Q6KGJQWKM45Z4OeyCq+kQB2jdNjfHjVlIFJ9H8KGR7fcHLdFw/bebv8Gm/ mCyvjSitlrNMX8bib2ofdK6YLoP2/3EnAtWC9w5yDBYtekxlMPL763KhXVtDfLc2jDaCICdOH+4u 2CLKH6NlUI1plLw4yI0iDdtmIgEphJqTNU0jklSCoVSp3YJ4HJcRI7mdUVF6qiRi321hHuqXetwZ C6AKRJGhuM10p9zIjzoBSXES1bC4HvIxk+7DznV0u0H6CKR9lCRBlPKroGYmsKPytIDE6dbO6shx qrnctO6pFpbx0VPtDKg2/Qqbbv3OlcrTyVEUuNtHwXdOAyLV/ZBGMEs8wcfbaTi0jNjI5f/ifZRu sRHtuHU/Run0OCpIqZJiqKqGm9dCzzfYE23MoA/r9mzb3B7t4KJXyvNv5GyqeYrkZqa/GmkSOzLZ TN/RQqc03Lo3PMoTpyF9EiVSxp4OH4yqJsrgK3oO+PWQniVT9RBb6T2ije9OD0dDH0kF0k2wfjOb E6Xfw/ip4Q039TZCIg2SpVsPFUj//V3I6unwsJvEew793Z74pGzIQSV40R/NTwwxbT6cayd6oCWL E50Szc/13hKm724fFf/1mBAV3WQkTYuRjh39vwj8Bc/fwDPfaVqjAAAAAElFTkSuQmCC , from which data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAANQAAAAhCAIAAAAu4xLlAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABIFJREFUeF7tWj1a4zAQVThLoODjBOYEQENFmy4pSbMd5XbbJCV0tFQ04BNs TsBHQXIXr35iWaN/Txxr2R1XJJJmRk/P0nsKk6ZpGD2EQAkETkokpZyEgECAyEc8KIYAka8Y9JSY yEccKIYAka8Y9JSYyEccKIYAka8Y9JSYyEccKIYAka8Y9JSYyEccKIYAka8Y9JSYyEccKIYAka8Y 9JSYyEccKIbA2OTbrS8nk0WNm2+9mEwu1zvc4N6jxs3Wu7x/YMCY5BPEm7Hnpnm8QiFXvz6x+cP9 1DN4t15ESBlvDdVy9dg0z2yGf1dQk/yvBvF/Jh3l2a4qVq22/lzRxv0Qs4/423qM2PHWpmuev1vl vM8Zs7/MqQ2B4JHCqkosBJx5tn2CC2JgbuBsxhFQ6ceKk4swQ+CGGeJbVhlHTyIBBAggZ+eFVEMf au3iiL9A0lCNQ/Mkd8oYnFviddNX2QAcWQUoBnnjyPEaOjtBPsLjkC9AlrZM2RwlnxUATz6TYJBs ImaAsQOyL3/KOOqpTQ9iKdnRTi23gFgcHsPMAGnaA2Gh+YSy5o+yAfsPg+r63dvLhs1vHaUnVFWW /hMBqtUPnFR0DujzU/XV6XnFPr6Uf9mtZ0sWyjC9uas2L29DOJ3sKQ+s/ap20gcWIOPwGL8N6T09 u4DV6mQJhE+4CXi9le/L0+u6+3Bx5tP1SES2nxumC0LEqH8tNwGngYi2+dyqUaIsNU9FvWevlxE9 Bbx6GCLliEOm9w9ztlnOtP+qF9dBnxapq0ccYQTB3pKNsKlQU/qzE2iBqgMBHHVlHSnxY9dz6KkB lXYdMG+s1TiwoTYJKkitTJPo9Dko00rDkMP90AZK2pZ7usacAmAJEU1i6pUeCO81X4oefXB1+sYV WmvOQmvrFVyu9bVFSPtZCRKztfNpCs6OhJ1Ls4vx4gMMn4cgMbbmrT0Kdhjanb+x3aR1tu4RiONd nVyEFfkGVNQ+vFLUjq1E0CYbidI7Z/yWxyahW29qBr1ZcjTyuYGhH2grTRWQEye5q2hy+RGWl8zS EOSovL0bkf7E9wxqU5QP+PmUdhpS8QY1WazV8BnyCluZoqtbLptaZai3tByABhV3KLSFkIVr6fiB rCLTcerF6fLiPeUYYwhL8mUbAmGVYo/pgYwpCtOD0uvCaVR3N7b34asCaL77+uAna+vn4q0AeR7f 6zNMlybfAZ7gEMeUtdxOJxTaonTt4WVIiE5uKYk4/Neq64/VVt9V1Av/xhNFWBy7ebtn75PFPhfD kj50BISOXHjJaR8r8VajKhje/CRCGuUeQZWkTj082rY4g3BEDQe4EIzFcQCxbv7aLAmEOfmOzz2g 6k1YO4XfvZB60WNLDrW+zx50ASMW3Ln3t7XJ8Io4OmU85eBIAE/wty8Hc0A+2zQbstnrtFyYnb3D vl8Y5xcOjKfJcRr4xUrY1+Nue/iyv9HIDIRHI19P/o2yHaeX8i8pI13ot+wx4VXnatAh+nGhmuOR hkh1aAxuXISmDpioQ6PTeMbGJh9hTghoBP4Abz3Uw/HA53sAAAAASUVORK5CYIJ= . 130This result can be generalized by distinguishing two cases. See supra note 38 (providing a description of the basic setting of the model that is used to generalize the examples in the text). Consider first the case where the principal and the interest portion to be repaid to the debtholders at are lower than the return of the middle state, i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAFYAAAAQCAIAAAADNR/RAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAnNJREFUWEflVzGWozAMtfcsTApeTkBOkKShop3OKUmzXcp0aaAMXdqtaDac YDhBHkXgLqwk24DHIUDYaWZcyUaW9L8k2/C6rtnPHr9+NnxEP46CKl7xVVx9FV3ZjvNdBtafCF/l G+xCI9T1VXQ9eFFJq3KUkceMFVQW147GbPEqlANbUNGZIU13qAB2w0ZcDJFJCgin+k6fGpcwa92r XV6j2xMLOJzCEZiV6rbQpmEmCWUkhLChYLLbRvDcNyoFJ7xEXl6UNKn+/mHB1lE14oQfENMl+M9F WRZLf402bUE73gZsf8JWGRp9LVsWzHXbzdmpCCC5BE1SAEjz5UIjxZXbHTvfXh8KYeA7Nju1PQl0 vFTxMSFvttAac7aBJ0PqG2SQ83d2qT/CLhIJ8M7c7WKpMpvtjq7PNGRJQVnkQiZCD5OQmcDVdshQ 6kOx344rTgI5wdKioG3BdKsr01xV0MEgNc0D+DKVbOG8uURjFafuJWRFruqeKMjSRLeBSn1nOhq+ DobzTcKSDSVFp5qMAMbzGtjOl4f6vKbZaOMPFdGjgg4Gn9hqOgyyHb8XfuggZNXhSEF1v+kp8nHa 5+Jg19JgtOuzPh2N49DMC/qKfr8E3U4LevRTIpru1L6RpTc86BzohP2mOABbEAbThY4UQGL0FHjd JOKqKR1uwUFiTIVXD5f+fYp4xcRDKiDjEh90guQfzbWMyouuGZ8vs85tqe7Oft3miuy/FCdel523 ychLER8Apqr9JNCQFVb1Lnjy2DBJGPUqeRFon23jbTIqgElKwxSo99knbic5maFsZ3WGscdbOSxP 7Ofvpj7uN+m7oTbw/AP6s20RFAGjogAAAABJRU5ErkJggk== . In this case, the condition that determines the equilibrium interest rate is data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAYQAAAAQCAIAAACZX59lAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABVBJREFUeF7tW7126jAMdu6zQId7eAL6BJSFiZUNxrJ0Y+zGAiNsXTuxXHiC 8gQchoZ34Vq2k9ixE8s/Dek58RRAtmR9liwpIrnf74SO2/Z5Rj6+Xnv8eU2mhIx37GODQ5aiQbZt ZdUOUBrQToe7ouQW4P4QRP5wLZzWSzIdC9fTe/3ajRs4gjqL3utqsFyfHsK7fUxbAkoDiulwl5Xc Btwfggh3RqfDfr76+TDotEiSBbga/SEDYzSZ7w+qN6JOOmGDTUUMmPC8vSEo3UlqtpD/JPw73SwM b0naA4q7mqQZCNApdYd7rrImcEeAYkAk6BxgJtM07X6ck+EmhSc+0s2QTVW+LH72fjrOxYr6g8J7 fpRZUGlUQai40lB/A9GVb4BYXc9bfK6q2i2UNVn+7MC7TaC4ic3ByVDAgC7OXIf7DxljbjEuoIAp lS1HLBTsGMwmDJHR7ftCBk9SeYjmaez48RKSaVDPio1TiumUD2ejPxREvfF0ePmuDWtGb4Wa0g1Z 9vPg47adfU5TITaPqN4v3LHG2YhtC6NdOv2coaOyGjV6gIK5ezQa246cFqX7eSHsJgFcWL6NXb/D nWvaFXe7JfqCYkKEmd5w8xGaRZlNGJxRej0P//adTp0XcXodTEYwU39Q1ztfUxuDTODe68dmmNHf /n0WlS/CXeoHrcTHG/YtUAiFGYZxbR0o9u3ctu/7+XHHIKaDQ2TXWLFwh3t8YwwDxYTIMC8u249E HYVuwtQZab44jAedDRlpVi7JPTdohYU8+oPCsPc0IPWhEfU5ZyWSE/T69yE7YZuA8I89sOALtQXE FY8Qq2WgICRmdjTnt81p0V8OoAiJ0hhfvMMdtBAd9wBQDIjUm1hm99z682GomppNWLxNQx02HBFE hRdWgUqn1/XinYi7EgIVlkDpD7iFc6pCv9lXqmtyXM5ETlO8w4QmzZf354Q9MA7oLSCu+AhCOizx 86CwtyD0smPJ8WFyv7MICa0xzF463DFaUmkig6JDILMb7YzFRUO1xwylwRmV/JrErfB8L3uyf8kI Fc8Hu89zysuerPKw3V2T5hlcv9lv4GOdk0zrRqC7YUQ1dh6sqFWxT7HELwLHJKlWY5lbBSjIuygQ FBQXeqdDAA/u50hevN8hVqu5wz1JMu1YD7AgjAyKCoG/RVRAaXBGJe8msSw8H62GF4V22fMBG5FT QgVn8xbRiLkkQr9CLNqTcXbvSkBshDPylL/eO6K4l5CuAAV3F4WCguJCXXcWoPb/5mU8/wNbntnh LvqTQTHYIxQXFBkCGgFrr7BQl1aNCQtnZHl/5XGkTovZJ/Md2y2yPQjJRNIvJB9SyTROtUYOuXzS v3iVq18ESpakMeXBBeEcrFrR73C3qkgjkCKQGKDIEKyX4m2UMVhR7k4tTauCkjojqFNFG7RV6rzs 06TiMPlaDejjjIzdgqPaEh71x1Jqw14jSwlU6U0WK1/0l2eeUbq2ItSnx5UKixQPtgwU6/mAS3Nw nbFsEi6I6q6QqqU63EEzUXEPBEVFpGR6cqnEejpkgjoTNvabWZvclDTNSu1EoPUJak2PdcuZOrXq 6CNvpCyrpemxhrvrRpx0HJ84b230XrrDnanOFfe6AxwISkDHrt8pID4K8GOFm6W7nqwfHN1IDe2d wT2iOGllqhLbrMnUVxLXU+kucMQZVNjANvcOdwFHPNwDQXEKAqKcJeaMwB1LNpP3ageeLx8Bm9eA j5SNzGkPKNbthqMWvoJVyN9CEAv3QJUGTvfRNndG7O9p+v9QmndGD9CAj9YamtMSUBrYbYd7KcZ+ uDE+ApH/dS98KTozXQwAAAAASUVORK5CYIJ= , which gives data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAFwAAAAQCAIAAAAUF48YAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAldJREFUWEfNVz2WgjAQDnsWsOB5Aj2Ba0PlEbDUxs7SzgZLPYIVjXACPYGP QriLOzMJIRgjhEV3p/ANOH8Z5icfu3+AknAU5dwPUwifk1B5waXyaBQm8MOkUnOIeRSibhKGCRcm I8RVzk2+KvNC/0uN8gO8ej50N9lT4BGl47xw4VWeMd9zF+dkeDwVdiF5PrtxlTwbBhNk0vg6m6LZ 0peIoPTFxdLdDvSKG3iGJ2NS0rnjzFOU1xi7QEHa84ftdYrbFYWL3YatKUltKM9IyV0E2RaCBuXD 4dtBigN+/GdUiW0YJC7dZgGXNZWmrDqdaa7mR4mqrLGuKT5Tb2DdR3a9ozYLNaRF35WRYlhl691N SZE9qTP2OVGbXWgrY6Zuz/jHK7dK0rtE96hjSop0ozOd3OZRJEYgrxX5VTpZqyuJKduDJWECkkJD GYMkhkpPzn6d0VzXZnrVuVoJ18sanvrJC0TYoVteJ5CJ/TcaYU9Vi6y/tD9YkjnsJydviZPaBwN9 Y4xt1sf/kuEXnV9UYNv2af6mTYup2UJPElAptW3Uk1lbM+L2Rmqd9s8zh513Eh+0b+ydFumpBWA1 1uo7Qi4LeZyO+TVe3locph8RdaHaNnLzbarTuv409tEGanHKfIFN0rm3vFyWnsAXptmLuMMZI1bh MAnldEZou1M/s0VQZuzzoXVQnI5sILAJB4dIe8Jyz+HKOA5AYo0YJ40PQ1LWGanrDliW0xMlk4gw 3Qv660qRn7jdR4C6mq0mcL6Nv/IA9bEroGLEdXVGNVYh5xITJWxDdWakH5Upv9eJlPzeAAAAAElF TkSuQmCC . Note that the interest rate is increasing in data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABMAAAAQCAIAAAB7ptM1AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAN5JREFUOE+dUbERgzAMlJklpOCYgEyQVJnCtGmyQbo0pkxGSB+zARPkKGLv 4kgymOPgwOEL7g/96yVLOOdgE5JNLjItOetSiLJG0ZSMnVRnHCrbTVKo65HplIRMtJ1A49LOKLjc Kcl+P/l+N0uGaW11e0r98P0xIUvxa9r8zH+mhFUU47QEyYHEPDWqwBnNHGGhYyfKUUTavoEvLoKc aOHuoceaiet0FdM2/ikA0qxoWhN3437WsGUfvxYMPKuUuCKje6g1G7+QlrEp43ZJuHfccoMqeb+A 7/43BE28CT/vTF2mKs2KNwAAAABJRU5ErkJggk== . Indeed, since in this case the debtholders are paid in full upon realization of the medium state, they are more concerned with a reduction in the probability of realization of the middle state (i.e., ) than they are interested in a marginal increase in the probability of the high state (i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABMAAAAQCAIAAAB7ptM1AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAKlJREFUOE9j/P//PwNZgIksXSBNBHRuT2dkTN8OVIfJIGin1YRST7C70Bn4 dd65dUVHTQWoDZNBwLW3r+kEgG3EZDAwAMMWCLalQULKasJtEDttG0jw9gQrsAAWBihGoNrAKoBK 0tLSrCD6CAGgTqAdEH0Qw4nTB7ITVSPMDEI2/v+PFLbb0+NXgfx6Z+JEUAwSBIjQAToTHFBEWss4 +NItHs8STLc49QIANXMLACoVbvAAAAAASUVORK5CYIJ= ). Consider now the case where the principal and the interest portion to be repaid to the debtholders at are, instead, higher than the return of the middle state, i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAFYAAAAQCAIAAAADNR/RAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAnJJREFUWEflVzGaqjAQDu8srAWfJ8ATqA0VrV0ssdnO0s4GSuloX0Xz5ATL CfwohLvwZiYJJAsoyG6zO1USh8z8/8xkRquua/a75c/vho/ox1FQRStrFVXfRVe2t6x9Brc/WHyX bbgXCqGur1y34IYlnQopQ5cZJ6jMr5rG7OWVSwPdhfTOdGm6QQlQdxtxMUQmKCCc8nf6qTEJu9a8 /MptdAd8AYNTOIJrhXp30YZhJgllyDnvQsFgt4XgOm+UCnaQhG5elLSp/v1l/taWOWIHH+BT4n9x UpbF0lvjnd2FMrz12eGMpWII1M3Y8iwL5jjtx9m58CG4BE1QAEjz5UIhxZPbHSu/ez4TPRY7lT0t yP8qOsVkrbtojdlb3xUu6bK+1AnbwUXyqmHnqjtztouljGy2PzkeU5AFBWWRcxEIJSYhM4HLz+FR TT1I9ttpZdGCjGBqfQS9C9OsykzjVCQmpKakgl7VjmAyL+w3h2isotRJAlbkMu+JgiyNVRnI0Gvb 0fApsCSbmMUbtWlTFdy9rIHtfHmsL2vajb78maKiwkv7MqKpMIh2tCu8wEbIssKRgup+U1vk43zI +RHDMlEgLaUYzyFFuBG0Fb6/BP1xWLBvg6ReLXJKlyy94UNnQyUcNsURmAc3mEp0pAACo7YQyU3M ryo8/SU4kRpd/dXHZfg7lXs7lmAA+hILIi7wQSUI/vG6llHR6Br53My0bil757Bu0yKHm+LEdqnN Jn1NcdSE0h0JFGSJVc4FD4YNk4RRU8mLQIfuNmaTUQ5MUnpOgZzPzAlxko05yhjDmVPRM/MWKMyo 7Z/w6bi/ST8B6SCG/6VdbRGoLGMyAAAAAElFTkSuQmCC . Here, the condition that determines the equilibrium interest rate is data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAUsAAAAQCAIAAAAQ68pJAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABYpJREFUaEPVWzl66joUFm8tJAUfKyArgDRUtOlMCc3tUtKlgTJ0aVPRXLyC ywr4KGL2kneO5EGTrSNZdhw1EUE6068zaIB9i5btZ7N9VvaT/T4pPuYj+vgjS9EHv4HzGAYoPRip J9wHYM+eNJUwY6J/Tljp4LnH/4SHc0GScw9r6jewGAwoPRirD9yHYc8+NJUB+49hS0/H5HUz5v0O W7oejdYp8jM6Bdf5MjmecEjV7oenEW98KqHhhKfDnTDSf0iDCuVXgip+xBYsyXBA8TeTNIMAOoy2 4N6Kq2Vy5/YcjKaq8rYMDqUEH6Sm9faR/JzkFM1OSRx5q1ncKGwgCkpNrz1mqtg4OGJV4FBBTxNG 2qAbUZ/6k6DQpcYiTLQCFwroYpto4JTTkuETVghZmNHt2YGmIXpV2Nj9AnP4/evKpo9SBh9v/vF5 /2rTOoQrakaVkvHXVbABhlqnGjR+Xs2uX40JeP6nWg3Znm0fyjR5P7x8rrJcbJH7d1cRrWqapyKm 5OV/OIP5e7b6fCHXDw3cA0AJSnoujbyIgj4LxjdZiMsb1lxU+jbcAegkSaTlAPhuL+DfHzULM6I9 HQsjvqaYmer0ooFg9wv08Ox2mU0eaFTajMpu0+UcCZgdlezllrn4FAKPNx/7WTH+/veTrZ6LUCXi 1MfKRcrne7cKsFLzte1D1xw7OFDc6twPu2NyfucQQxMQuS1WETZwz25sMqm+T99uKzgRriB2y1SO iGrP+JqivYL00kxg+gV4uJEtPOxmHypvQctYiFbhydnsKFTGj1PWnMTBkS9KzZGPN//fRhOuBBYq vMPLBJIKhCKEINbAQCFIzDNFIkJ4un7YTvFgh2QxQdyC+/2LTZ4fp7njp+vdZMl06EmSxV7k8TU1 lrSsV+FP4mCnbPoJj90vxElbzIb1y5XftGWr29t6x/KojimV189mx5N9Zd9iourvnuRsw6HCPy1h z3fdPY14h3Mgq0AoQiII6UGie1D4cS1kEL43Oi2/v3kuJ1vMCgKUZI/jhwkv0++H0+Rjw3oqN5tN G11TKTjaOM/frQch+iba7hcWD9cihcSyiiWLIzsuioFKLEHty/3E9chey6rNY0E2DhX2LYZg4PLe YzgVgZX5PgeLXaavsFT5p1jiV6fso1G9GXVuNaAQo3tLUEhcoOrAOhN9+swWwTcIkuJlgQ/lweHl ttyMUQ+zlnWiaYHOac8GaOJrqi7pwJVW4xcWD9fihcSviiXKpZ4cSyQMcFe8/xPRM4QkuX1zsdK3 7cX/oo+giGAUKH9zyCFx12CuAYUW3duCQuIC8bAopSDtRqhi0tMVAzlU75ft4oaZombr0ok9a1c4 343E1VRe0lADGWfYPhHW8Ivcwx2n1wFRJV2/fHKHPByI19hEJpJ9sfaUznbi7IDl4iCk+o93GvCL QClqdG48jLreZZWBPoQlYX6IFyLSBpVrEt1I9pRyZRxN5ZABFPPjaGtmVQK9WqXX+oXtQZv7+rP+ YU5xKQeXmLzrfcVnXIxqbw3lpaBfdKtzixtkMcN+Kd6oSMg9unp777gPb3jf1OIm3YSvNSjOFYFq w8VWDk6g4SSMzKvwAs0m2hHtWUsqtqbqKg1wGHE5qdwJyzbCV6u2xwYOSDt8emd5W1g9maesNK8H LpEV0V/nhHt4AChO43Q4oHzXEswjRkhrQNPXnrWkhqEp3cz8Xbqv9nTy/iPNp/llfKJmBoz/3qWD v6T6DI1tkTdDJRkSKE7jgLBUdGpodf6TjEj2/AWaqhYWvzwxSsumwtYJd5sBnQPdRrh+5w4HFKfe 7VFrT8FTyPKJp19kai9newpOTZUB+W/LbL/pOid+yvsxto/uW/0YMndHw1Ip/gQo3SlYUu4H9yHY sx9NJcj+B9ox9+kb4t/jAAAAAElFTkSuQmCC . After some algebraic manipulation, data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAALcAAAAQCAIAAADbFXmeAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAvlJREFUaEPtWTGWmzAQlXMWcMHzCewTeN1slTYdLjdNbrBdGijtIu+l3YrG cIL1CfwoFu6SzEhCCCTE2IZ1eEHVGKSZr8/XjCyxP+M3pjWMloZhKqIW0VqaabiOCvGwep2G2jh8 6/ITpTisiMIokp6M4a2I7lgALeSANGBOphyTsiApIhOwc+6SKyCMKaLIeKyxruHni079SLY+Gwzh B+yj5LGKfPW8RSNLLl93Hn9WfrDAR2N70Aa+v3jM4Qec+sHl6Rv7sWOX1RI9GcMbEbM4BgjdscrT G0M3GjA3O45JWZAUFsDm3NOICxXnjlwBL97Le7p6Own2nE3DY491FT9dgkSp8XVuGvdnH7HwcGHI ViUXPdEQwgg/CqGO1jq6jsgXZL3+zd5yqa3XgPGa1WudVMt9F+A2HqmSKgkijDr79tJzLTkit8sP 0uSnsUD1wCrTmkYvvnaHKrjGNhBlco/9ar2YYah+KAD7YlF8tPtYJ0V01IMH1RGRy42MORieLpUo zZoGcdq25UlblH0BqFuFPj9Tev/YOXepRCU/07iFXJ4FXGmC6HQoP8RwczfBAKiEV+Cqvos6oLbS pmEQ19gr1xsqS9qAngMIhQMexM+sASoDDP+LghZwl8aNMfhXQrrT+VB+qOTM/SQDvOLoe+4RmOn7 0za//6cZEBUH68sd20p6xRlBgCO6HCmvjoh4PNdwqgYHSGdxEHVTa5zO1EDFUdD0Gj9uK+PNwv9+ HgZ9tt9nw3h6mBdQSZGfQ3EC+t+3bL9IliBvOOLUz/wIvMDIxQLVYBrbw3OywZPe6TZQCSSDwywS +IRlnATFjVT4Aez7caxpIMO/2c8p6+Qz7nEmsobKUx7IuyQsOVBxjk88PVAav2XBjqaBT71dkFNu XyihHtBnVklFenW/x39jyeFNSy3igtDesuQotnamIQZ4S5bDFR/2wNrEG1WBD5BFK+SskooQlQRo HwU3uPil43iz/xW/HtkF7rlLw1DO6jva6gIrZa9TqUJ/ATPp7HUIngCuAAAAAElFTkSuQmCC holds. Also here the interest rate is increasing in . However, in this case the debtholders bear losses both under the medium state and the low state. That is, they are are repaid in full only upon realization of the high state. Therefore, the interest rate is decreasing in . This higher interest rate would compensate the debtholders for the wealth expropriation they bear under Project III. As a result, the substitution of Project III for Project I would no longer be profitable for the shareholders. Indeed, the higher gains they would receive from Project III would be offset by the increase in the cost of debt: i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAi0AAAA2CAIAAACEBT5UAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAADL1JREFUeF7tnTtaHDkQx5s9C2zgjxPgE4ATR6RkEJpkM4fOSEzoyUgdOTGc wHMCPgLDXViVpG49W12Sevox859k17QepV+VVC2pWjp6f39v8AMBEAABEACBmQj8M1O9qBYEQAAE QAAEiAD8EOwABEAABEBgTgLwQ3PSR90gAAIgAALwQ7ABEAABEACBOQnAD81JH3WDAAiAAAjAD8EG QAAEQAAE5iQAPzQnfdQNAiAAAiAAPwQbAAEQAAEQmJMA/NCc9FE3CIAACIAA/BBsAARAAARAYE4C 8ENz0kfdIAACIAAC8EOwARAAARAAgTkJwA/NSR91gwAIgAAIwA/BBkAABEAABOYkML0fero5an8f 799M29/uPx7dPM3JIqfuiaSlalZEJYdgWVqyHsdsqBhJSf92YEIT6boMyBi50CUzKKJLZsBiJ437 obf7G9tFeKWln3KqPvv+Ku49ev/z5ZiT+kDTkMFfNQ/v7z/OD5RApNnnP97fH5or1zkff/lD5vT6 /QygSgmgSzLIoUsyIJUl6enA2iyHn1q9//qRklu/x+umif7RKl0mp4TWL8gjK/EzRWRzMtrDUlii J2rOPxPSOkNhvBltO9Mi9TVYjbYxFDkt8NN6I3hUNE69iXIcaJ78JhvPhHogyGJG1XTSMgd0XaMP mbfclnJ5km5G65IpRXutGk9X+9clq81nXQU0ncX3GkWyextXExhz1Aupnm0bvSxe/IH+K2QIautM 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Fig. 4 Contingent Contract

In reality, however, the scarcity of observable and verifiable information leaves debtholders incapable of bargaining for contingent interest rates. As a result, in order to protect their investment expectations, debtholders price debt through a pooling mechanism: they pool firms in risk categories and price debt based on the average risk of each category. 132 See Charles B. Cadsby et al., Pooling, Separating, and Semiseparating Equilibria in Financial Markets: Some Experimental Evidence, 3 Rev. Fin. Stud. 315, 318 (1990) (“Consider a situation in which a firm’s management has better information than do potential investors concerning . . . the value of the firm’s assets . . . . Investors take into account the presence of less valuable firms in the market when deciding how much to offer for newly issued securities.”). See generally George A. Akerlof, The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, 84 Q.J. Econ. 488 (1970) (discussing the concept of pooling equilibrium). The pooling mechanism of debt pricing, however, leads to an inefficient allocation of debt capital. For low levels of adverse selection, it may produce cross-subsidization effects, increasing the likelihood that projects like Project III are funded in place of more efficient projects like Project I. 133Cross-subsidization is the problem that arises when good firms (i.e., firms that undertake projects like Project I) receive worse terms (i.e., higher interest rates) from the market than they would if their nature were known; whereas bad firms (i.e., firms that undertake projects like Project III) receive far better terms. See Tirole, supra note 49, at 252. More radically, for high levels of adverse selection (i.e., when in the market there are many projects like Project III), it may lead to credit rationing because debtholders are aware that the demand for higher returns is not a perfect compensatory mechanism. 134Credit rationing describes a market condition where creditors offer less aggregate credit, with the consequence that good business projects might risk going unfunded. See generally Joseph E. Stiglitz & Andrew Weiss, Credit Rationing in Markets with Imperfect Information, 71 Am. Econ. Rev. 393 (1981) (modeling credit rationing in loan market equilibrium). In the context of our example, these adverse effects imply that Bank Alpha’s shareholders may either face a higher cost of debt or be unable to raise the capital needed to finance Project I (recall that Project I is Bank Alpha’s available project at the issuance of debt, while Project III only is a future possibility). 135 See supra text accompanying notes 36–38. Explained simply, the pooling mechanism of debt pricing reduces expected equity returns. This serves to produce a disciplinary effect: in order to minimize their cost of debt, shareholders have incentives to send a signal to the debtholders that they can credibly commit their firm to sound risk policies. 136In economics of information, signaling is used in the context of asymmetric information when the agent has private information that she wants to reveal to the principal in order to obtain better contractual terms. See generally Michael Spence, Job Market Signaling, 87 Q.J. Econ. 355 (1973) (defining and examining the characteristics of market signaling). Since a credible signal is always costly to the agent, it implements what in agency theory is termed a bonding mechanism: i.e., a mechanism that protects the principal by imposing penalties on the agent for a shortfall in performance. See Jensen & Meckling, supra note 7, at 308. Debtholders, in turn, incorporate credible signals into the cost of debt, moving from a pooling to a separating equilibrium. 137 See generally Jeffrey S. Banks & Joel Sobel, Equilibrium Selection in Signaling Games, 55 Econometrica 647 (1987).

Consistent with the common law view of the debt contract as the essential source of debtholder governance, 138 See, e.g., Prod. Res. Grp., L.L.C. v. NCT Grp., Inc., 863 A.2d 772, 787 (Del. Ch. 2004) (“It is presumed that creditors are capable of protecting themselves through the contractual agreements that govern their relationships with firms.”). There are, however, some laws that are designed to protect creditors’ interests under specific circumstances, including federal securities laws that impose mandatory disclosure duties on the debtor, rules on capital regulation, fraudulent conveyance law, and the equitable powers of “piercing the corporate veil.” See generally Robert Charles Clark, Corporate Law § 2.4, at 71–74 (1986). From a contractarian perspective, this minimum set of “creditor-protecting rules” can be seen as a mandatory contract that binds parties even when they have not bargained for such protections. See id. § 2.1, at 37. the negotiation of contractual covenants giving debtholders authority to condition the firm’s decisions is the standard form the shareholders’ commitment to sound risk policies takes. Among the several types of contractual covenants that allow debtholders to condition their debtors’ decisions, 139It is important to emphasize here that while this Article examines banks as debtors, the general theory of debtholder governance is based on the benchmark of banks’ conduct as creditors of non-banking firms. See Triantis & Daniels, supra note 4, at 1080–81; Tung, supra note 4, at 125–26. More recent economic studies, however, have suggested that bondholders also engage in active governance, mostly by bargaining for risk-event covenants. See K.J. Martijn Cremers et al., Governance Mechanisms and Bond Prices, 20 Rev. Fin. Stud. 1359, 1362 (2007). there are (i) informational covenants that facilitate monitoring, (ii) investment restrictions that constrain the firm’s discretion over investment policies (often in the form of veto powers), and (iii) financial covenants that provide for minimum financial goals that the debtor is continually required to meet. 140 See Tung, supra note 4, at 13540 (providing a detailed description of the various types of debt covenants); see also Smith & Warner, supra note 35, at 125–46 (examining the ways in which bond covenants are written to control conflicts between stockholders and debtholders). In addition to control covenants, all debt contracts typically provide for exit in the form of a right of withdrawal upon bargained-for trigger events. 141 See Triantis & Daniels, supra note 4, at 1084 (describing the several forms that exit in the form of a right of withdrawal can take). The threat of exercising this right offers a powerful governance lever to debtholders, allowing them to dynamically react to unforeseen contingencies. This happens because withdrawal can trigger insolvency if the corporation is not liquid enough to pay back its debts or is unable to refinance. In this respect, the debt contract only represents the reference point in the exercise of active control by debtholders, with the threat of exit forcing renegotiation and allowing debtholders to “complete” the contract over time. 142Debt covenants are often designed to trigger further governance actions upon violation. A typical scenario might feature debtholders threatening to exit unless they receive monetary concessions. Thus, renegotiation is often an agreed upon and standard feature of debt agreements. See Greg Nini et al., Creditor Control Rights, Corporate Governance, and Firm Value, 25 Rev. Fin. Stud. 1713, 1720 (2012); see also Michael R. Roberts & Amir Sufi, Renegotiation of Financial Contracts: Evidence from Private Credit Agreements, 93 J. Fin. Econ. 159, 160 (2009) (reporting that more than 90% of private debt with stated maturity exceeding one year is renegotiated).

So far the discussion of the governance dynamics that address risk choices within corporations has assumed away the role of the managers. In reality, however, unless the corporation is controlled by a blockholder, it is the managers that run the negotiation with the debtholders on the shareholders’ behalf. To this extent, self-interested managerial behavior also matters for the governance of risk choices, demanding shareholder control of such choices. This is because a manager’s compensation contract may fail to perfectly align her risk preferences with those of the shareholders, even when the manager is compensated through equity-based schemes. 143 See supra Part II.B.1. Thus, the manager may have private incentives to undertake riskier projects that offer her a remunerative private benefit even when these projects are unprofitable for the shareholders. 144 See George A. Akerlof & Paul M. Romer, Looting: The Economic Underworld of Bankruptcy for Profit, Brookings Papers on Econ. Activity, no. 2, 1993, at 1, 10 (observing that bank managers may invest in projects so risky as to be sure failures as long as they can divert money for personal use through these projects). Moreover, equity-based compensation might present additional problems with respect to optimal risk choices. At the time they are granted, stock options add an additional layer of leverage in the managers’ payoff schedules that serves to align the managers’ risk preferences with those of the shareholders. 145 See Bebchuk & Spamann, supra note 74, at 264. But if a riskier project materializes after a grant of the stock options, the wedge created by this additional leverage might make such a project profitable for the manager even when its undertaking is inefficient from the shareholders’ viewpoint. 146Thus, in the example in Part I.A.2 it might be initially optimal for Bank Alpha’s shareholders to compensate the manager with a stock option plan where the wedge of the manager’s additional leverage is given by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADcAAAAQCAIAAAA9EHCfAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAW9JREFUSEvtVjF2wyAMxT2LT0GPkCVT1m5kzAV6CLJm69opS/EJ2hN0qnMX KgECQTAhHfrc98pgP/OR+JK+9DxYa8Xq18PqGSLByHLa76f1MoaKW6MiP6ln3GG7bmfW0h9RhuB7 3umCmv0y6hGpheMItkbBA8gwmkgtfqLBjykGQxdr4cTfjqtA+YWCmDmW+YJzgSQ4qDBMeG9ekchy qAwtDkIuqeCleUhsltGSDimBVaDFuB1XlhWpNelQGWQZ053qSwVwWuygQGybmkjFrUXCUO8t+HLa TL2iTJbnEFkzlVe3oct6ULnkKzUpGiLFCz6zeTludvLz6+ISOJ1PcrcZxXh4Vh+vb35zeV2OjwOs 89ba98NYngP0SbxUAHewihIP7yq0uO/xvOEonJbmaYq0VMF7b9YKJxtr4Arq2p08Yk2h4nEWFlqg z4Bf8+gbTtx9VHk0raJZV6A+M132DpRfPzf8/23c6Lh++G/8E30D302mMQMAAp4AAAAASUVORK5C YIJ= (where data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAA8AAAAQCAIAAABGNLJTAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAOZJREFUKFO9UrsVgzAMNMxiKPKYwJkgjyYVI9gladJlgzSkTEagogmeACbg pcDs4kj+xVRQRYWfJZ9Pp7MTrTXZHeluJAIDWgoht2+CEt3zgGONwkpUNRXVMAMxWN7DCgsUIzhC QoqMPCXLPLFDZslpPQw19Y3UZ2RVienyOHZnrZ/A7YUA9ypco7gDojGssEhGkBpXvSc0L3ivqjYL zqAOGBBoxva9WHUrv2lZsWm2J7J7GdG0vvEAT4kUScxX5GZKmJ247enakMvdPsbPS8zcpP4BTOq8 Rll+Suv3ViT/+FXbPwoQXxVt6mEIz8EZAAAAAElFTkSuQmCC is the strike price of the manager’s call option). Indeed, setting at a high value induces the manager to undertake Project III, but limits the positional rents the manager can extract. Positional rents are returns above the manager’s agency rent, which is “the minimum expected monetary payoff to be left to the [agents] to preserve incentives.” See Tirole, supra note 49, at 117. However, if a project riskier than Project III materializes ex post, a high can make the riskier project profitable for the manager, while the same project could be unprofitable for the shareholders.

C. Governance with High Leverage

Examining the factors generally at play in the governance of corporations sets the stage for discussing the case of high-leveraged corporations. 147 See supra note 13 (explaining this Article’s specific use of the term high-leveraged corporations). In particular, the discussion that follows will consider the specific sub-case where debtholders of high-leveraged corporations bargain for rapid exit from the original contract. These exit rights can take several forms: for example, rights of withdrawal, acceleration, or conversion. 148Conversion rights allow investors to both withdraw the value of an investment they have made and simultaneously reinvest this value in another investment. Convertible bonds, a classic example, allow convertible bondholders to turn a debt participation into an equity participation. Puttable stock provides an additional example. This hybrid financial instrument gives the holder the right to put stock back to the issuing corporation for a predetermined price, to be corresponded either in cash or through (newly issued) common stock. See Sepe, supra note 112, at 151–55 (examining the governance implication of securities providing for conversion and redemption rights). This paradigm fits the case of banks, since their business model employs high leverage and most bank debtholders can exercise a right of withdrawal at will. 149 See supra text accompanying notes 29–32.

With high leverage and rapid exit rights, the debtholders can promptly gain corporate control by triggering insolvency or converting their investment if dissatisfied with firm performance. As a result, the threat of exit grants debtholders an extremely powerful governance lever to “manage” unforeseen contingencies. Anticipating the severe consequences that might follow from the exercise of this right, shareholders will have stronger incentives to distinguish their firms as safe investments. This leads to a theory of efficient shareholder signaling in high-leveraged firms, which serves as the counterfactual conditional for banks’ governance dynamics without insurance. A variation of this Article’s running example on excessive risk taking will illustrate this theory.

1. Signaling with High Leverage

Suppose again that, after the issuance of debt, Bank Alpha’s manager may have the opportunity to substitute Project III for Project I. In this case, however, the debtholders anticipate that Bank Alpha, i.e., the manager, may switch to a riskier project before the debt becomes due and, therefore, engage in monitoring. Assume that, for the debtholders, monitoring has an expected cost of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACAAAAAhCAIAAAA3RD4GAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAUxJREFUSEvtVksSgjAMLZ4FXDieAO5Tll5Ft+68gSu8ASdw2OBdMElbmv6s LJjRGbqBNmle8vKIFtM0iTXXbs3gGHsDyDK8UbRRlGUg67Cp6Lcoel2aon1kc1rmsHqTBfzg4Oqk k5js9Llvqs+jtaTexnNN0TAKAtAebuITzmirEQh3DqoufsRQLiw/AJgDagAqxwLweMF1twaTKT+N AiRJoII4fdyTV27PZ4qgdCmJosSKpcddE+Bhk0MIJoA0/zq+6S/2mJwNAOZijfE6tD1qNHc9QcjO A9BaShLtqooxFCFQ1RR+aOXpBlK73qOfdHVQCv9mke8TAB5tZEDUhwqC4PBoLi8bbhx6IY77MgAo 90ch+mFkBuULFM3thzKRQtxrKj3dezy4uvF8DZnUA29OOFJxbU6DA2FyCZk2hk3Oj5pFHqtP0+Lv /76/Ac+4ENuOLrqbAAAAAElFTkSuQmCC , which they pass on to Bank Alpha in pricing debt. Thus, the initial equilibrium interest rate ( ) of the debt contract is determined by the following equation: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAi0AAAA2CAIAAACEBT5UAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAADa9JREFUeF7tnTlaHDsQx9s+Czh4HyfAJwASIlKyIWQSMofOnJiQyUgdkRhO 4DkBnwPDXXhautVaqtTaenqw/xO8Z2a0lH5VqtLWrQ9vb28dPiAAAiAAAiCwEIGPC9WLakEABEAA BEBAEkAcgh2AAAiAAAgsSQBxaEn6qBsEQAAEQABxCDYAAiAAAiCwJAHEoSXpo24QAAEQAAHEIdgA CIAACIDAkgQQh5akj7pBAARAAAQQh2ADIAACIAACSxJAHFqSPuoGARAAARBAHIINgAAIgAAILEkA cWhJ+qgbBEAABEAAcQg2AAIgAAIgsCQBxKEl6aNuEAABEAABxCHYAAiAAAiAwJIE9icOvd5+/nD1 tCSL91/3u2D4LoR8/7aAFoBABoGFe+Xu49DT1Yfh8/n2NYNUYVIJeKEAJ5tKtVGJ1H8Qegv1Gss2 At6JieW1YBCuXLT6EvIkTki9s162s4pMo8lezHXtBFTLJ9k9w+k2i3vw5Ofl+/GYdvXYf2v+Z//s /Tr+FGR7XHUd+eXx9xenBpnQ+th5ygXrW+XXNbaX/sVveuXfSv4QqGFO/1RQaYSh81NSqwfqzaTr GzSXom1eUnbdSFFbUmsLaFdmkRx40RSlCfTxEirFy8s+AqfcRo4GJhpFVVTuH3IcF9mLI107D2CQ midaWbB29BnuN9N15PkNS92diUHG7oNeoArvZdcVjX1kDDWBDZFRSDkHB8RQuvy/KNdWrldZlmA0 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QmCC150Assuming that monitoring has a cost data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAYAAAAQCAIAAAC6IZmZAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAFJJREFUKFNj/P//PwMqYELjA7nUFGIA2ggE29Jg1qRtAxl/Z6K115UJt8Ey VlqqQFVAFVZgAShgwBD5j+wuoAHp24EG/f9/e4IVxGyodkYq+hEAMrpAijbyUXYAAAAASUVORK5C YIJ= for the debtholders, the initial equilibrium interest rate is analytically determined by the following condition: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAJsAAAAQCAIAAACOdJrAAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAzlJREFUWEflWD2W4jAMNpyF3WIeJwgnABoqjpCU0Ew3JR1NKENHuxXNJieY nIBHQbgLKzt2/BM7kYnnvRnWTUiQre+TZMny6PF4EDqKZHZ7/9xM2Mv/Mu6H2Z6sCVlmr0N8XDuv SHZvp9dhhY3IyeYzW2KFf4gc9WiRjM4rc3tC+I7YSAocFTphdrjjhD2lAKGKw/JKkYbW7mZkAPBk 88XijzzmGqK0ghQsRpVG+odGjom3hPUvVDjOleWG/cxjXR+sBhq0b+Y7TiGwtNCBufQPuT7nHkCh BqvLpDj8FinimtnyKCPJvcQM0fDTRGsbRVEja1MAVHz8DWtaxHWEXR71VMf82ROylFXbRL5ucJpU X8gLP6+jyEQQvf1ikpPNKY3Ka8Ve7n//kPVSHKmgNAGcExw3wo3qOl3NW8tNlmuy3SNrghcYnZFI 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Suppose now that, after signing, the debtholders discover through their monitoring that Project III may become available to Bank Alpha. The debtholders also infer, but do not get additional information about, the probability that Bank Alpha will switch from Project I to Project III. For example, suppose that the debtholders expect Bank Alpha to undertake Project I with probability data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAC0AAAAhCAIAAADCurW2AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAT1JREFUWEftWLsRgzAMtTNLLlUmgBHSZwTSZo80sAxswAhpYBfHH4wtkHw+ 7ILLmSJFZEvP7z3JHFwIwU7wXE6AQUEoOKAQhY/CR6g1iz+KP4o/4i+vf+2X4cV53c3xRNiV8v0j 49M3jDX9gYRs2aMSrE/VTniqqa0YI6NCheloEJ3CoTGs+3UtNJ2J0JUOk6HeCQ0O/xSm3I5dXaWR P8SJ9bZDmiiirC4eaZqebcIFq4rhOBI0QXAQBlgZI3GkaAJweEbdHtjTjcCRSAamy2LGVRdYwuKQ /3rKpcPA/AH6B/QzmE4OR6omhE/1GCDciOiSgQwJRN4vc1fDUTx9R8but2vUcB4+77F6PuIWBzIK c3zXqKGZuY/l0MTpAl1ADSO3ynZUHk0of0RfU7nIwOdpLIy0Qb6pwst3B9A8PztVexBUUKvBAAAA AElFTkSuQmCC and Project III with probability data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAB0AAAAhCAIAAACqSTeOAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAStJREFUSEvtVjsWgjAQDJ5FO0+AJ0AbKo8QSm3sLO1soMTO1spGcwNOQCW5 y0oiv7AhJIXv6XukTHaHYTI74AEA+cKafQFTQE64H2EnHSYduiM2+eEH/cAiz1sl3BiFZf66ricl hD7NXUQ5LmKf+HFhbBmuESd1e4MrSMg1gjtIVqI27dK/Qq97CFAdGXTjyelCaBigEhYt9ktac6ty MkgBUlyL8fnjlvnxAZWyaJ3HRRq2HU7zxs77jB53894DJepV3XbAFRpoyOpQXb4XUoPtRiXLkxXm SspdxWddo/S9pvVBYyJ8Fd3+YVwbYwOIx1Q2tdNXXBjSwDjGVrjsXpoW+6APzF95uyV10A1EkwB2 GkgR2olV80EXDDYpg/vGcOWbjIWXho73Z/+pb/uugJN5G/ApAAAAAElFTkSuQmCC . Further suppose that, given this expectation, the debtholders threaten to withdraw their investment if Bank Alpha does not increase the interest rate to the level where the breakeven condition is satisfied: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAATMAAAAhCAIAAAA6U9stAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABmZJREFUeF7tWz16EzEQlXMWm4IvJzAnCDSpaOnsMm7oKOnSxGXc0aZKQ3wC fIJ8FNh3MfrZ1WqkkTSS7UXAbIUXaTTz5o1W83YzOR6Pgi9GgBFoDIGrxvxhdxgBRkAhwJXJPGAE WkSAK7PFrLBPjABXJnOAEWgRAa7MFrPCPjECXJnMAUagRQS4MlvMCvvECHBlMgcYgRYR4MpsMSvs EyPAlckcYARaRIArs8WssE+MAFcmc4ARaBEBrswWs8I+MQJcmcwBRqBFBMauzMP63WSy3NZBsV1O Ju/Wh9RkwpC6tceexUCNjXhr68m/zxzr2j/MxfxhX73cy0KIxUt+ulqHNDBv6s+MYKD+DO5NrSrG 8ibCNlVt9kqWbcSALsNgYoLbOdoHBvUNfQXbAnWvKAE56V/OebVQfAyCFTp4iBgPO71KF2zaSCrv IwN+PGZI6EZCeDLg+BcHNVZlYhzWgNiiMq5HixMvgi5eZBaGj81AfAsIDA7rqn+BiSV1qewSsmpY gg4kOK9rImoggpUHlBk1eGCWBR7lPUkbgXn3FzgT4NTNMEdCdzfzwwrWiCJTEdQ4lYmfL6W7LtNT cUcNiMXCLxhnz3bM99jgz9hujh4EDLo8h5wn15q2TRyNx2mrLem8XQet7DC0nlegNJEVNN360iTB mDGSzPu5AC+ozBQJve0YYAGXSCFTE5RSgJRqIi+jy3Q/MkJLWbd8+P60E4vbG2/WzePxx93U3tz/ 3EkGBKPU/ysD84fP0MB2+f71Yf94G/Fl+uHjfPf0vdeL5GLHR98DODVicP52ZsbN3s7F6y9j8LD+ tBK+R2WoIKMjQAmC88YaCpTOahwrDyg0CIsB2RPETG/Ey/v0zTUcPCLgQkGbIOH2eSPE9RtL0ptb uU1tnjEFM4NMcVBXUit9vtVb+uZ5PfxwvDmZb0LVnPUMNaeUSMUdvHi296vd4otTxD3XvsF70LTK +O7nnuq+Ji9m0NpQYRhcTF0mV6cuC8blgUqbxYDKY+UCNb37shC71SergEtYNsIHPxNcmRHNfndH HhFwEEhIwsOvV9nB9DuzHdxvzyU5Lg7q6u6HrYbNk/imfkyde/5TRT9do1fFk9Y8o2cr+byMXIf1 143/wIyWkW+DCmLMoHpOdnukYpAhUKQAShJ1ibEYUPm67DyxQKm9/+V6NeuS/F5INTxz2AiDoRtR Tsuzsl2hHvDutFdDzjwJ+xCVe+VXVVDmsByoG9RjOmVcpHmCUzt9IhQ/QikH3uldl3e9yWhQWKuW Nmjb+q7ZGpqGQW9DJKVhGp7JiGqV1ImSfSameXlCbQQrABRcw4QY+prpeGlGIjpyJeAUKmbG+CQM oyR2+iFgxUEZBQhN6hkidYQVwotMKJO5ogx4iRmnfGVlkg1CKSeht4XQ0RSg3AaZ4gXUpxz08I3B xcpZNsLFYL/I7hGwmg3lvfyQdmxHOysCvJa9gIRhlAkJyFEes6/tBzpEg9LfAGnhgdJZnnBgIBwB kJMCdkBTJyXncmiFHLooURUYdISf4XArlC5Q0NESoCgeEjnJ0kPrgNIyHAAtEGjyvpGMbJez1fVL 7qBcAPh5yAlIqGMPMpuWTPLwuPJhnEW6MsnCg5foYF9yVS7HQxVtyFzVcIPGNEyoaujmHz8M+i0h bDtEte8ng+j12fe48OOqtiUu+mNxoAgWzwaUJiZoziMqSMqpvBGZey0W92L5dolLFDIuVGnDAK8i Z4aEOhJHi/W1WkJqwiG0oFRlauwpD5cqP+QkpcvjWvNudd8r0FoKgEqP3lA8Tdb3QTuPXfoFQkVV Rw2qVw+buDvnADAOVBp6ClB9ogNLACjtAdBm5eYoaDjqh5Z695YzEkjbmvAIhS8OuF4zQUKtMovN VyNVexS18RbVRZZFvVnTZNK+T6k9u3cSU6juwA4PaUNy3elgwB8ZtM6DXDMAmfLINxj0cbBDyHzg Q+szo0AlnSeqBBGskNkgLR4OCU9gDxY3gvb1uGYSfHtkbqA9dS07kyTsV+s4E3wD5hQOiWAEFnUw jvMNUI3IdBL6RLLSk4lqM77eRjeXGFnseltAnQWDrviCar0I4OfymGCnhEWjVWZhcZ7yID9lLgHe yw8pKc5Tgj1l7uVR+M9XGLMy+5cOlzw65947/DXpvnTV/DNA/TUZLXR0IscXNbA8mBFgBEZA4De3 jUdagbiFYwAAAABJRU5ErkJggk== Note that the increase in the interest rate demanded by the debtholders is the result of a pooling equilibrium since the debtholders have no certainty as to whether Bank Alpha’s manager will switch ex post to Project III, but only a positive inference of this probability. 151Formally, the debtholders only know the distribution of banks that will switch to Project III. Such distribution induces data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABgAAAAQCAIAAACDRijCAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAARdJREFUOE+tVLEVgjAQJc6CFj4mCBPwbKgcAUorO0sHgJIVrGzECWQCHgXJ Lng5SLhAUAqokrv7/37uvrKu67wtvt0WJIrjH5HMQxbmctrunTKWvq0oPE1/IuN9KikxpO48E6TC OpYJzXomB3FkEFmCYKD5waI7mRJDZPOv4uk1D/KRyLzJftZQoiqUXITgYVQ6ysZh+5ePEVREsz3C wJ8xQOp7yPAQHPyxqGoE2Zpsa89KUzboU0Siqarg1hUR3uam6dcvX48qiR1pA4BOPLu6KvhxPyqC dsNdI/3Tmdet8Y/q5FBMw3qUZLK9I8hGcMazAnuzamsWZGJQB5z4lxgNiJZ4EKDW7fDlPOxpgyz9 ENbG2VZ/I1+KMBxLfbjaPQAAAABJRU5ErkJggk== over the support data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACsAAAAQCAIAAAAAghH5AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAATxJREFUSEvFVcEVgyAM1c7S11MnoBN46xQ4QTfoAHpsR+i9dAMn8HkQdrEh CFZjI5zkQiof8uH/pPkwDNmu47BrdpvcMjD1JcdRfv7y+ZTsMtkX8OuBzXapjWcAs6g0yPEomBcR 1Y1bJjsDfhkUD0ilpN8QqYLp2/PpGK9YwNNgeUgkA92drykvEPA02GZghUNHYIBimfr+bHtUjQ4O HzZyJ4AmuhLOBxhKZX8LkWEgFX7/N1Lx4RzwwZgzmzNAhHXJRuYZo1T8mGNksOIDME+S71PxCyEp A/N+NVu+B+1D74jBc0VEGeiukc732KnKGvuVn7Bnwa2nMyd8fLHOkCs+8CJrrSphDQN+c5NEwyrp jcu6lF0kTnSkiP2UxE9u2q6MOEK+Hf7UAlNreOnx7vYlfAnF5YpC5bv/O38BrZal3fplVxIAAAAA SUVORK5CYIJ= . Hence, the debtholders demand a pooling interest rate equal to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAHsAAAAQCAIAAAC5lpexAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAvhJREFUWEfVWD122zAMpnsWuUOeTyCfwC9LpqzZ5NFZsvUGXejRfa9D1k5e Kp2gOYGfBlN3UQCQoigSsiyJfqkxyCJNgPj9CErU90xKpkJkkp6/8ZlKVdNk5+W/MlFE1ibP0NZb EjlUu7RWKofRrXeMa8031H4uVfv1el+RlM3h3y6ZK+8Cf7V/KX/UdZ7RmiQR5Sq/9Y7rRWOdo1ix XSy2xQRLeY+DC0HeHp9GLM0s7NbeUIjVd/AzzqIWIbueQpqkpTWs+vtHPCzbwFZnGsYiX0scv4j3 monp5lDXT0cuFqCMltNjKlsyCso1o2rVKNFghZIZFrM3hHGWkxzzYosdEID+aX5nYw5oZbaKW+pG ezgOQF1jJWo9BFi9SxqLQzX5HE8SdTzJ911SnU+QvfoJoYMMg19vCGOTaM0LFrtAdlWunjYQc/Pb ME5OSRAwmXeQsTj+SuUbqJvsDoiMaO3z42WITB6fxetPBlxU2Vt8BhMxtgSOOqo6djZQBjab/OKG VoCTJbZrwNTUHYWuhS414jyfMPmFK2fnOG0X2mt3Nxug8s5eHBea0cly65isrUWfUWDdI1eK8l0U AA8N1dR1la2F5lLK2X3MfI+TMoG9GhG7TY/r8X4u6kV1YFA54zELfgwjdYeBIfMt47J4dnaGil4X c66ofGW8lKbk7dYT7xS7zImYh+5dRsRxQEcNYJbwID64E4MgeHkByuuXiI0WQ0xLxu9C/CN6oNBe Au2PjM6cPuK49NoU2yU8BQzqeweAxwgex83oYPwq0vEIiG+zybwuLR8AKa5PENZeVX54kuFQTE9n fcvAtOS9FE4X2+Ur+rPY6iQIVhCmzK/3aeU9lotXdWTPyQlhEaODK/zWDn607YS+FTc+9Rlj3/LH +nDUer77jZAxAWYbtfrm27/HNxd34nF9tWpvXswHrFGx6y6+6FinBXG5eqaHtbgPj7tfr7AHjvkB y/bLw86KsuI+PB6Yaj4nmDubpO9aGVw7HPyM4p4bCPkEiWbezX3oQgsAAAAASUVORK5CYIJ= .

The pooling interest rate compensates the debtholders ex ante for the risk that the manager may substitute Project III for Project I. However, if Project III ultimately fails to materialize, this interest rate will increase the agency cost of debt borne by Bank Alpha’s shareholders. Indeed, the shareholders’ expected returns under the initial interest rate of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACMAAAAhCAIAAADcc4UFAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAW5JREFUSEvtVTtywjAQlXMWSMFwAnMCUnGDdHYJTTpukMYu7S43oEI38Ak8 FMh3UbT6oL8jhhk30Rb2ePW0T9r3JBeUUrRIvC3CAiSZ6ZVW5+7l7tkdyI7IjvhvjpjaXbFrp6jw MO4CeI5HjZ2JuDaT7J/L41pJWNkQlXPepCkBYwFgWnVVBSJDvA5SIIDzUjEmXrNiDxOgicRaBSkE 1NJfLMHviH1HabefPSy4/hgb0h18ULlZi+R6U6LxLlo/tZ8n1HyZNdNuI87zc1yFFjPciEiT24C2 74ARPA4+hWmGB/bRX7gT8KVH1QF2gb9PQ3X21mWqHtIJcloZ0AK+WFaJ8LCS4QwxJh0kTcQdYaro OELXcTtnyW2V0F40XfkXk2N0taeZcyAb4LkyRafkG5wJ5Bnh4crnmKb7GKdlxukDRpATtqJ7Wjtd yNdBaxY43fa5lZeOqZilU6T7CemgfrYrC7iRFonndHplScsx/QLcwlLgJAnDzgAAAABJRU5ErkJg gk== are equal to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAASAAAAAhCAIAAAD2yuHGAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABoBJREFUeF7tWzt2GzsMHXktUoocr0BegZ3GlVt3Umk36VK6S2OVVufWVZpI K4hW4OMi0l70CP4/IIccDvX0/DCNJZEEwQtcEgDHk+Px2NFDCBACbRC4aCOWpBIChAAgQAQjPyAE GiJABGsILokmBIhg5AOEQEMEiGANwSXRhAARjHyAEGiIABGsIbgkmhAggpEPEAINESCCNQSXRBMC RDDyAUKgIQJEsIbgkmhCgAhGPkAINESACNYQXBJNCBDByAcIgYYInJ5g2+VEPVerg1naYXU1WW4b LnVU0Q21BdH/ISSSsIKxHStDb75A+TSweEPTDHCh0xMMlJw/79n/oR3/PEwHqPyZh4Bz3Hevx+PL 9adY5vXL8fja3bsbxvThD1h//zw/1zUeVkt7769SE5bqr3axkb/qPzYYXqtpCoZtFl2H/igJpsVD R+vB5/cHwWhnoNchobO/vLLvCW0dpymCUdoAW6TwRbylTPOwd59kvqAosHkWj+jPRYcYVa1omCMh VO9HWw3CV6BbO00u3ZEraQ+zQRYDTavhEHxy1ELpJThh91PS4S+TG8CuMUNZqX8U3bRiKZ1rTJjQ 1oOmCEa1WYTWii4/sgoJY8YaMyRLN4mYNdfiagPHeDoiwQY7UuhzPej5JHC7u62MYIEneBzwcHS6 2yRyCRU1tCdOE0oPYB0U7Eokto+ClgFR1ciUzhm+F+2S0LYGRrXLee6WXH4VwbIk804Lbz8cYHEd IrkMG/kEG+5IZQRDfdEN9ex1XnSHv+/sSPk6s0K02dd5t3v7LSoQ21/rrrv8orOl61sG+fqXLkfo oTDq/a8YdFjdP3bP3wclEixuVxkIhPDRbIQ12knc9MulXkKfzlVBtTtYaVsJ4+H3265b3LqAJZdf tYYMydvlzfvz/uU2nGeQxaff7ubap6p0zx6c60jZAqVj7xabSPUA3N5rvei4Y+4+9pFpEMeBnopJ 1tD9x04SUdDrNauEAcB365vJ1c+PkoWGfTmphIv26jx4pri2lTACeO4uN1jHUQZyekUsqJ2lyOIA UNzN6pUezZFSqmx/Pob7oNnXkVZWRRRH0pMum3AaJmaBk0o98FmeZuDgwr9Bi8WPLHqx3lBTYnHH br3eMaINLdseVk9s+k3suLN1rrJlXNsaGKtUajA4Qa86i5t9OenG5iZH1/PtD0HhnwurdKT3J315 gMsHzxab+My6Z7D6oq1Qpr9+YXHl7nEm13Df3UHBwIoK42CwRW0W7Pxhz81a+Dczjvxk7juiGkvJ ELGI3BBklZNMHJn70tq2dSVXYEiGF6ptBYzizM1CHDm6HXecsc1RGAS9bcxgIzMbcnqxX7ldRrJ4 Ug8AOPXEr3eGORI//Lo7djsikmHGBdRjuZUYuvwixfSV/oq3QhXRf5w0LszpwmzeEmBqG7H6YlB7 kqPZSJYc4gWaZGIZJsuFOg+peqS0NQsy9dI+lWKo6AJBbpk+v4qoinueZF1cDDgQL0iLlpjFJR5o +XjEKqIy42BHsgQEVxMxO1hkQJyUtSIXzTzfnt99E2UNPLeIpAtWbcNEjDwGzY2+pw+v7CSzaih9 W+52OXu83LilkCKd+yZItae0rYCxRqXqsd7xYdECCxAKLZ53SA+MLJylFzuSGd2TTjvT8NwjGviy 1pBgIo8zKRQXYXm8X6Gz5mND0dqGXV/0HYCBGYaEuem+iGZMaLhdiqO9QOcyh8zXthBGXriNVprK lDxh7wKLQwSVaddBIWK+aRAXdF/aC+vqYgjCPKjzyNg+0urER3iAxo9BWdtPBGvuPZj9zQlbYldU 4mQP7qETMRKI9e9A1fdMnUujQx0RpLSV6aQf/aRVSt0Kpa9e3DVUh4ihuGh0mmnx09yDZZkmdqFq hYQeB9yECGs0Loi1qhxMtCWhlMSPvETigh1E5O67H8GrAdam4rRJtZw9x76FDjZra7SVTPS/+JLN NC9Fwd8iis2XVClAEH9drydrySRYCliDhdEXWVG2xVWy1/hNDve9Oc+X0+t1jRp6Z/Bek/Y73xru PKwVK3JkO5tricAGRm1bjXSRY8Dc/8oQeYKNOndwIo8qfWRhqBlxi5/wXUTJ5RE31FrYRnqbHqLm oHhqQunS+vkJs4gzmopVwPd3b3iF+IzUFKrkW5wlylCH+r/+60QtQ4vHt4ncitU43wGpbOx8tcY1 Q885O4xqUKY/L4wmTJ2z2x1JIULgsyDwDyhOdwNKW2yhAAAAAElFTkSuQmCC . Instead, under the pooling interest rate of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADAAAAAhCAIAAAAQ6r/uAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAc9JREFUWEftVjtyg0AMXXIW44LxCewTOJVvkA6XoUmXG6SBMu5yA1fmBpzA 48JwFyLtB+0P78AMMxSrakFa6a3eW0HS9z1bk72tCQxiiYBCjMQOxQ6FOhDyRw3FDoU6EPJHDcUO hToQ8q9WQ/U5ITtUnXWQrjoM7nMdOiXD8FdJnBRYXr6EP8ZbDhX2ZQtLsLbc64/qjfQLb34TsR7j ydCGhDIIHWIfrgwvueD3VQTofrumtZ9X9CNSiXkGC5BeVF+LDlA+BGSZVdEB8AKRzDQCyCBBPWCs jt0SNZL/fgf2fo+y893zDqfNUks396cts6CwWPNoRVD7aNhuu4FVV30UrPz7xLWwAZBQdVo0wcRp hjKaarjrcuX3ob5eWH7CE9c/RZN/a3DgnU2YUBCR6rbfR4iZZSRi0LsmbiEeWRSvgkdD5q1zk8/T kCNV0rJx/3yD0eBks90xYl8R5YpqIoVCPF+ct4FBdjzlAMiZYqg5KTqI5/Ak+0oB5J2IQ4WDeEwt S0eaAWXW3BnhSB+MdE399IVUZs4h/akthYZIboagiXctwJmx2lQjcVLnnBlqwpHVaYaPfgMWcjjf DbMheQLPM3WwzLbV/n4sc9wZWf8Bj+yr5LxSMngAAAAASUVORK5CYIJ= , the shareholders’ expected returns are reduced to: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAASQAAAAhCAIAAAD/IUG8AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABrRJREFUeF7tWzt22zoQpbwWKUWOVyCvwHaTyq06qbSa16VMl8Yurc6tqzSR VmCuwMdFpL3oYQAQxGfwI0ico2TUWBGBwZ2LO/jMMLPz+dzQhxggBqZn4Gr6IWgEYoAYAAYo2EgH xEAlBijYKhFNwxADFGykAWKgEgMUbJWIpmGIAQo20gAxUIkBCrZKRNMwxAAFG2mAGKjEAAVbJaJp GGKAgo00QAxUYoCCrRLRNAwxQMFGGiAGKjFAwVaJaBqGGKBgIw0QA5UYqB9sh82s+9w8n3o3T883 s82hktvFw0yIFkxfEBPFVDIDoAlDDGCU8yA/Ewhjwhn0UVI/2ADJ8unI/h/d+f1xPsZU/UU2QAGr 5vV8frn9i7yKunL7cj6/NitzjZk/voNIjk/LaP9LaQD+2C6t9/JX9Uf32HraP3K67ddNg/4og02Z h4baBx/f7gS9jY5WgwBm2728fwfQGsrIolHOAeakEBz+JA+53jpEnSUI1xFnWBxhpjZQI9xGAoIc JgIzGKEFGaVz0sSI2WkUr6otb6b35NbkXAvL/dM+nuCbIQg01ER86O066/CX2XW4VajRCFU/imYK WAhzzrSgqw4bFEFrUZNFY7dwuKLyuu/xQgIL+8iNKuoEcGxO+mU4oPbgBIl+qdrAVpWxgy2gN5MW S1EYo3Y0yDY+OyzYHFVY3FhMGc31gDKDyzvpljnFperAGnRT25nUQ0ffDh2BdD1DmItjDdC5aEto 7FY8S9JB9wuDzUudGxuuZ8aRpKPD3nsHaAPbw0cOtpDeGOIQLRbjqCh5G5+dq+b054Mta18X2jFu 8XXZtG+/Rfbi8GvXNNdf1O3q9htbFne/VCpDdYVeH39Ep9Pzats8/Tfo4sEO8N2NBc7y3tsLe6hf +uZfrpULMcwjnvE7tIU0nn6/tc36m0lY0P0SHyzqjp8tOxSowTPYiyDM18b8/mGppFfiYnrfXm8B RTnmQOHteo+mHXx2rhou0vbz6EGHiAhadlGldYUpE0EpQu01Kf0B7Da7u9nNz890frCWXCJCMVHM g0fyoy2kEcgzV7zBGPM6Qkrm7oMlrNSiNiJ7Slbp2gAe/WrM8w1rnaE3TVGOpcPPrbs4etApOywb KbaqHyoNz2M24BXsYN0HvstdDkwKrQOQ9fekUGOtIenE9t12t2tZ0A3N8Z6ef7Dh975tUMdcNGF+ tCU0FkEa2lnUYBbBuRa2h7FXoI1+KQ85pxWRVI1A/+IUE7ixVL0FFSXjZ6FVJ/DRYOdRyoTU/+0L O36224UEumoe4P6snRz9HjPk+zXbl9jnbie0fth03/pCiQ9IZxhOI+KyCbbyA05spcfcfPmw2WJ8 oWgLaBR7cRLj7lyYXkDwiAlBq5lad3BDZkBg8vNZj0T5SNrwj9I54LuE+ytLcb2FFcWni9HMqzQ9 hwiFhh1RZ5MlDdHx/b5xbnG6x/yE3wujdxm0DnHcBd1iey1zUe12pdevffzJLF/m/sZiGkYKFu0s zBLA8NkCAy7a4TTyQ2jaeu6QZ3rhJqZi1UweFMbZxh4CZy9hRx1RGwmjZTfx6S1FUXz+FbXzx+9m JoNjse0gRW1+V18+3IuUCH4X8VwvtLxIf6rk59TUY/j88ZXtcFr+JcbgYcNj2tjUsjDHBgg9D6Et oLEE0qC+xjlxIvZytJG2xw88mBgMITOIKSrOKqfQWC5dO26wiatff+XiVjT127kqDQfriuZF9Dyl DZsx5u6+qakCtnTA5V5F2mEjDqwZmOM06i3S0WbSyBPA3ixVHshoazjfGyd7c+uahL1UbcAJLXH6 Bx1MIjPoU5TJKbIeWbs/bsc48OJFOr1G5y8u8OocVu3WilJIgVMVcZhlKHI49U9VWHVeoXBeONDq G4mYc2tuSWjl9dOuA4chhcpJAdIdB1KK2tY0u+YDUPGiWwxhojYq1NmCMxhVlPnSRC93s4zt1uaF MuENEiVn6xUQbSK5MfHxvDZk0ikro/37A2YUOm+aaAuH8UzIwvzoFW/nodY7jjk31Lq1wodWvcjn e7UqCMlhEH8vMPLmUkqwydnp3UBs+qBawRaaIKf0jfxgOe2oXXIw5utammeWnq0npt6dVcZ0XUfo s9MF2xDdWcHoKKwf00aCiVHubIVAanWfAi2itFruTDkOelZBtYESMPIbJMrTKWYwQuNIb/3D8dnJ epm5qOhN4p9vwNKCx4e3RaxOcmk8JWojLQV4ac6beKdc01Db05zuqrsx3YBTLeXTIS627L+oS7GO eYwsRjvYwIz1vOzVgtATAxfCwP8Xq52az1QqVgAAAABJRU5ErkJggk== . Thus, in order to pay a lower interest rate, the shareholders will have incentives to send a signal to the debtholders that they can credibly commit Bank Alpha, i.e., the manager, to the undertaking of Project I. 152A credible signal is one that can change the debtholders’ belief. Let us consider the case where the shareholders can credibly signal to the debtholders that Bank Alpha will not substitute Project I with Project III at the convex cost data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABkAAAAQCAIAAABshEP8AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAARJJREFUOE/NVDsWgkAMzHIWoPBxAjiB2lhxBCjlEHY2UEpnS0Uj3GBPwLMA 7oJZ98vngQWFqbJJdjaZDJBhGGAns3bCYTA/YPVZQIKsnz5ax4TE9SiKM3LrUl8l/LTTQXVQpcqp IjCyYABFlQTV3gqQLFYlXyzW0sIlDG9B8bviaYaFncqjOYZRNedBXOeNiBeR+75tILocNxeKO3CK kBGJ15vWWAZ9d3yP/aug/sHZhKrvCaTPqw2AHvVcdCbGNbGUmRTWZQ40cQjaCarhYc4hWrHAdj3I SyEUFI3SjH0Ox6PIRVRw03JjY8lWGK2MfGnm5kbsa/1p3k3m8VucC3Bjl5P0XKtriKzrBZ3Nw+RP /xMfB4bpHTcUptoAAAAASUVORK5CYIJ= , where data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADAAAAAQCAIAAADfzGvmAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAATpJREFUSEu9lbsZgjAQx09n0cYRZIJQWTlCKF3AkgGghBGsrGACN7ASdtE8 yZPk+wKSDnKPX3J3/8B38RqqM7CFu5RYHebe52qg7nv+tXQxlgalhEENcZVUACsBpZD4fbYG2jnL 4toayO2yFKC+0M+V1eN6FXIiiRsa60zkLHrLhtCUJzYAYr1uhwhQIBr3DBhQILJ9fFxpTjLB7495 /v7Z4nsUQSMMRhM08+kA2MgJDaDDZ4uJGkiZVBhPN0Z1SHmFo/EJd9Opn6BJgFfaiGlE8Awgnd/r 5zdQQKyH5Jk7KJ2GRRfcun9DTWRHI01oNmYoHS3ZJP1zV6EMdI2fKZkTzazoTDq9ZCnvj+FjZzQD dtjuOV9Cq2R/lBVATVwm9PwrK3X0ZYiefSWgNicopHWjL4MLxJ6BvJUbP1vXum/w3NjLAAAAAElF TkSuQmCC is the level of effort exerted by the shareholders to signal Bank Alpha’s type. Using standard assumptions, when data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAB0AAAAQCAIAAABlb+OGAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAJxJREFUOE9j/P//PwMNABMNzAQZOWouJGBpHA53JlozQkD6dtSY3J4OlUCl rCfewYhxFEOA6ez2BCsGqwm3ISwIg3SAZgjD///b0qCmglgMadtINxOoA90QBrBhMIDFUGRpJJ+j eQvDEHC8wRRtY2jBCDbPmVjdfzRfBS180QyBBC8EkBkGIIvRDWEcYuUDddwLTNtooU0dczELRQAm PD1YSK7bwAAAAABJRU5ErkJggk== the signal is uninformative and data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADEAAAAQCAIAAAAwDgDYAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAXRJREFUSEvNVjtywjAQFZwFUzCcwD4BqVLlCKKEA+QGNHZJurRUaWKfID4B Q4F9F7JrCcmS1tLOkGGiBlneffv2o2fELb26Mhd52YWGky/SmDELkXKvJc3n7ge8SL4p3Mj7BCdg JOsE/J+zspywEfelM8ejJCVgzGEeScxE1mE1p+FYh4e92nEp8Q0pYpCQimymc+A0MaupUbIR+JYB q7Gr3s+hXc1h38r33cK0Tm3661msl8FpVczU2jbGIVvl7aVz/ZuttnN/iqof22GQ8UIY4ITH8nXj MSIf+6rITm+oClDa89VB9x02R3KEfoLcbeKQGqLMRf99avNVxqEEBRXlJ4JiacMacjAIGz857J0g WkTBN18fot1n2IsXUd+O8dLyerdYrm2o7qKqM9xkc+OdW+1P7ui5lo5QPjDjNrx775CVJ02kFlgJ c1WLLRq0SJnwGjWq49xYD2qmz/R/f1smxN/WIBx73eAnf4MHotjvZ/5X+QXRr3cDtv2z3wAAAABJ RU5ErkJggk== . Instead, when data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAB0AAAAQCAIAAABlb+OGAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAKNJREFUOE9j/P//PwMNABMNzAQZSStzGakSDoyMjGj+po65mIFJq3CAmntn ojXQLyCQvh3V8u3pUAlUynriHQxHohgCDN/bE6wYrCbchrAgDNIBmiEM//9vS4OaCmIxpG0j3Uyg DnRDGMCGwQAWQ5GlkXyO5i0MQ8DhC1O0jaEFI9g8Z2J1/9F8FbTwRTMEErwQQGYYgCxGN2SIpl+q lz60ym8AxJ49WOFXTV8AAAAASUVORK5CYIJ= , the signal is fully informative and data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADQAAAAQCAIAAADWJ8ucAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAVxJREFUSEvNVbGVwjAMlZnloOBlgjABVJnCKS970Jjy6K69igZ7gyxBdslJ thPHxrmYHDyiSvGTpS/564e1bQtLtdVSgRGuBHDNacd2pybShSoZK9UL28NnNXYTeV8mFzd3qD/u EdhrkkMf3ed6kgMDZFx2KJ2XUBi7Soiag1eDo6FF8qdWpeu2nYch4OC1mfv965lPAkcBkeSRmu7p vfj7LrqaARvCCWCYTSR5LgTiMBH2HMGNNR6eu/mGYOaOjhBZcgcwMCOiXkFz/anz7Xpy59SxAvH9 +QGAXp1t0HmmUVJe7L2URkoSSqnLGepqzdAOINsvPw0E7ZHIRCxQpH2RVUctRao8nLksLlaYcGAZ AfUp50hg6OnGPpAM7zUsjf+7ELaQvx96W4f0HXLW49LIMgQ9PLyuf12wOjcWMk31VL2Zg3oCXDfX uMrSxF+kv7oXRlq3VEv48b8P+i8PdMGEJe9u5wAAAABJRU5ErkJggk== . The signal has the effect of changing the prior belief of the debtholders in the sense of shifting some mass of the distribution data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACQAAAAQCAIAAADxiUp0AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAUxJREFUOE+9VLuVwjAQlK4WfMG9q8AugYTIJZiUIijAboOIBNOBK/C7ALsX 3a5Wn10kPzgOUIKsN9pZzcyijTHqXevjXUTIcwfZ3FW66uY/d3Xear09i2sgozF9c1Wq6e25mdpS le1EHw8sKMyuq1jUEwC1AwDVf5h8u6GGI5MduCc8g4vEce8gz+bLWNbrFWy6Ksg8nw7D9ycc0kIL rAd2s2Ai+ksrlFmt63K8WMstGZYddgVAip36KjJRgCLHDfQ47ittN6yLAAdQcajRYERSfVrDz2R/ XT5I16ltYhrY+0lXjFEwNk1LtEICYx0kyxomxE6szgSTJ1q0FK0HGcEwlVOFie21TmDgHxslH7te 7eNccut9Qzl9hJAATDACgB+0OI5H2kV/aV4T3wQwDOTiuMvpuUHmc/HIbKNm8p6Gcpmov+bojj/i 5xH/Ags2K2DQWitFAAAAAElFTkSuQmCC to the left. Then data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADQAAAAQCAIAAADWJ8ucAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAZpJREFUSEvFVb11g0AMFswCLnhMcJ7ASeMN3B1lMoDLdGmgdLq0VG4CE4QJ eBQcuxBJHHBgv0AItlXYcPr7TtInoK5rFQoAEELIBN/qRIpQ0YOWRDbnbCZD/uUDLY07aKfW2jBY /GhDGhzgE/2PPnguJqnKPHt1LStIKaUpz8dQfMRkfNp151X0TieJHFuv8G4jFn/jMCb+B1X4XJcO gOtBWaHCcQBV3y9k1GP7ivP4YFnnfaOoyuaK60h35753w65yo1mpQmn0G7tJp23JGqf/NVUPSDci MG8gEMIY8gUOCj0YxnmhjdnWw0yBONtMcH/MM2XepR/wrr+/roW9znDMjZIGFglRcDy8ZT4IkhUK 7gROg0LecK1GwFpUDSNRXI+3k803WV+MKhAwDcrcQVeKnfNW6MWeGo+FeiPF7lTX+zPf/3J3dnbO xu99VJEJ2kgLky9za/fOVVKTUq+sh7KVcFxsU+Mzo8FbWIK5VLu73SRbmWe/zMotEU+Aq6ISya+8 t4fAm6xc/IQ7M9b1qaItkW4bDSl/q+r9ABVS8Ju0CGZKAAAAAElFTkSuQmCC . Therefore, as long as Bank Alpha is undertaking Project I and assuming, without loss of generality, that , Bank Alpha’s shareholders solve the following maximization problem: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAPUAAAAQCAIAAABBWq4DAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABX1JREFUaEPVWj1S6zAQVjhLQsFwAnOChCYVLZ1TJg0dJR2NKfHMK2ip0uCc gJwgkwLnLnm7+rN+LUtW3vBUZBxbu9o/7X5am5wvOZqyqFpcoCnLRl2oqdh9NuApDJjQVmVR6DMj xJOrcZq2KkgsM6DhIkcsHDsVBSNlRX//4C8uSW9qF7Fsf8N8y34pTsioCMnIy2JFXcaGDJqmFLfk 3baqGtwAEN0VBLga+RHSmdGNuyU6vkG61PUDonJbUO5t24BoF1oowmQXmQomVJNKghNyinWlRFv2 y/Z4S7M26Hh7PWXs5+80Y7P8/b3Guy0hs9nNYfFInu7JQc6MEWe3mmyXjNuYsdvW5fNoLg4JTm+P x2csVPTZdErAMuPF9ap6erub3L2dok0BZpysdtFkGsF8WdbbkTyCEngUtOW/YHyf3l7qww8Yefe6 2fsl3q0Wm2M7XX9DtLe9M708gEVN6sUk5FNUvxt2AEB4Fzczc5kMTj99fRJkPH9nQX36oX+zDHQ1 HTww8f8j+eC5I24JTD7Lrd+MbK3ADpjdFLkCXOoGq0p39SjokD9nMfhlvOzSqNyRcLcT2prPMEVR hGCOUZJtMwQnJFsOKwI/udCKmOP80McDngWPNBp9Oj5hpxR2bOuWHaCgOuWC+Tsudfyr2SJBT9cf VbE/AjaSoz3u9fSNReV8/ngYK9vp5zCWhYceK071NAfIs37HyoCF4uF+JEyb3j+QzasbYrTHQZVH N2yK8oDoNqRq30E3RHTrb3Y1REFV/itRcngpwCrAy7hSv2WdwHviTzc1Beql6DyWBoyz1+E9xU98 YBQmgf+gWLBxgnP6J1CXIC6gF8ze6AfAZfvNrMMmuoIuKmudDgNI3AEBUqiWERExWa22tTCRn/n0 +pZo5AnKI6Z1HIVsD8pwVHCTIv8V7AyocTUc7j6wDBCw1nZJe3b7zy/qfDAAfSjuYVbDPgPmCcBa UEEueFJKMI2fBOKsXLKEwMdl4jmr0NQB2yUU3cPLHfhGHtaZ51gXhqc5dWEPlS4bTJp9PnBgo8Vk l4EhkBcH1tRakpoZcBDzEWbAXGO4ysktLD8NW9nR6S5dOEe9x7FpTzNvhHpq11JrKHY8le6asZDE sib005t/+FRr0fmQou9+WDAhiQDJySibOclq5jsPDBo8DqzcWUSfqDJWrGbEhJe5amjbegPsZvlG WM7gFpZ/EP4WJWxm9UH6cNYYbyohyxqK1lBqhvHMt68gJ9Caw4anAEZsyk4w7fg4uJjJAj9kTRSe Am1lYLHuT3IuKoUBoHcGbyaTBWn0IiBOIojwudUM7Btg7tUq7FBKOqC0DpA/HN8dPBHtWwWyNGTx v4BvAuhEwY6Lumzsqj4WNnqd6ug7UmznABYuHg7cCe8NzPMwMYCzkwq2ldLgExWsIS9dv9xDB+kN DLhbMXLnpCFbdcAcRPCyx6gKbJ0MgvKLoIWyxl+xYRlULuU11McS309gvwwG1kFeauRbZeU95Zjs nYlWLWZCIW5cZ4/LfnmpU3kbY6H2n/u5/cLVr7eLgxMeaAXcRaVN6PQzXjkqwE3ACXy/jI4XM/1K W0sEO4oOxVUUo8LISPkzvZ/HV+twAolxWaYg7mET23qNnS+XDsS3u2Ub2hQh+8QeFxi/sIcGNJgD oml5Itmo3kUCHHX588Q38sSsnrJRQ35Mfx5t2miCkGzsszIRUzT/mZ9VhVj4nvfKiskv5fOWVDpN SD3AstuUb1Ongrb8eeJbIvOwUWXdybgXPDzjTTs+d5meRjwkjJLvsyqqcEYDpm4yF51hw3gn5BTm nCm+o2UyP5iNZuCEbLrLU0w7FjX068G1puFZwLeS9BxDDzW/NVqj/WKmiBQnRC/qJ/gLPbJHPfOU 5AsAAAAASUVORK5CYIJ= , whose solution data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAsAAAAQCAIAAABP3xIpAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAIlJREFUKFOlkE0ZgCAQRBe7SAhMYAEjkMQAUMMAUMQT0GVdED//EA/MkVnm zS5DRKiqq9vktkxYrUMCUI+CjEymUB5Zuam1FpwDzvsxZ3glcmVpHpGxadBDv0yeHBpc3U4/hUjM yCNF+isD0vOhl03f0j1yBBqY84Z3SqVlRH9se8loufoR85+xAer2nHmjFBWFAAAAAElFTkSuQmCC is given by the first order condition: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAJUAAAAQCAIAAACQvapzAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA1lJREFUWEfdWDty2zAQBXMW0oVHJ6BOYLlRpVYdWdpNupQ6AFlaM8lMWlVq Qp3AOoFGhai7KIvFhwQFcgGBlhOj4HcXu9jP2wXYxXVUWVrUFHFdpIxlBV5/8ivnwY/GAzWN/I+M LE3TrOJfqgzexEz8RXxsS8QPBq8k7spTzI56/MNkzFG3Ae8JKwtL1XUFbw6OdhCrRDai6yLTIaT9 Z5UoKfu0/jr++4YhTYxdHm3n7y+xjexcLo8/dG7EMTtOqh5SSoz5/3w6TB5ApLrD058N419wJI/s dIa7VSJQHjbLqE/r84k9Jn7a3IH6XE6jacnXRLsjyneSiE4ECVsKuEwGSD4j29opQk89SKHkCpxE yDREySQyJYI+nF7xWpFgMPsEmmiZgWvQCC+trfS5NhuFWlVhVC9YIM7lip9964B5xlzrkLmuwVAt osVFISN3D6GwDIERPKfLs4jA1sTmWrrevBJtVP6mwIMHA/3nYI5x7PCpcXLzErh5bBBgRhnpvksF oyjg0m4g0faB/uOBEZx/GF0a9cZpfrxNrtE6axBlQDFdVMxaZSrvZh1LDsiWkABy7nen/oUqqCH/ oWpv56DJYTWFdgMesGm584AGbXYQ9WXO1tn8CeQPK/b0Zo0Qo3ODzouJubwGCE42C64MNws2ab1j D/lHhFKH11TbLcLIZLBN47Xm24iVXq062sGykPX1gWfXGp38a5ShhHNGyD8ilDriXCwF4Rw1HS7N AYGaFt87gUo6PZxAarbbrtPFM2Y936LIR3y1KYZcuMTr0e3//cEElGH714RPPWPV5W04fUfAz/R6 K5U8QhNPSG55FYy2918oHRbeFLs8eeWa7HKxvRpQzAE/44cJW2/lPg38rbdsHb3i54UJk6qIVmw1 tB1E7cL7F0v74nTU1qTPHXtLe842O01z9xesWLs0DfRlBoK69S5YHIP3D/bON3jZ4cj4v83gvQ9T lr+1/xQQUx9FteBHP1Fe4vVXuVozom3yRrZeBt9SO57kUWeKX94v823kfn62ZL9Fr0tHqgaBFlK2 z6x5ozvisTWtUENRw6bWONfwYf4StA75J0u1sc3g8QJDbXf0ITKmw7QssTvLc3FTR62jRqycbDOL ouVGviAMOAbxRyjzCXP+BR/Av/bC2rlAAAAAAElFTkSuQmCC . As long as the shareholders can credibly commit to Project I with probability data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAoAAAAhCAIAAABvO60fAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAGBJREFUOE9j/P//PwNuwIRHDig1Ko01fIZLsNyZaM1oPfEOwo9wj21PZ2Rk VC04hup9sDRIakPA//+3J1ihBQ5Y2nPm//8zPbEF23AJNUy/AfMYtvBgYEjbBpRgHMAsCAC+wiBE +ZGzXAAAAABJRU5ErkJggk== , the equilibrium interest rate will go back to the initial rate of . This implies that signaling will always be efficient for the shareholders as long as its cost is lower than the net gains the shareholders obtain under the lower interest rate. Thus, the cost of signaling for the shareholders must be lower than data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAALwAAAAhCAIAAADs01ZhAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABCxJREFUeF7tWjF24jAQhT0LpMjLCeAEyTaptt0OyuQeaaAMXW6QCp9gOQGP InAXVpJla0YjjTw2hXlv3KxjaUZ/Zr41X2an1+t1opdmQJKBX5LJOlczYDOgpFEeiDOgpBGnTA2U NMoBcQaUNOKUqYGSRjkgzoCSRpwyNVDSKAfEGVDSiFOmBkoa5YA4A0oaccrUQEmjHBBnQEkjTpka KGmUA+IMQNJctsvpuhK7GL3Bvcc1Ovw33mku2/X2MnoWKcCBGTD/Ccte+xXys9r75+0/581istic 8WP7MLrInNjRtTGia9ip/ChxVnrAxIWGyrCz2OR+SqDBeL+6xAXlo4NVTBelid37mYC/rbExcj6g cQs8TZrsOjQ3NbycAT8qyLSf6vwZzIm4XEhtOHWAbBwZbGI/kigY/PhFj+uCUdXQc7xpFgkvbCoP nleBNC1JfHLdttNY2vXtPfQdAif84nKSdtFY8KOSXCOPDXYXT4jL3MEsFuiaxybzI4uif10EqGx9 QSYc3QhrHAlWYWZS0zx/Xj+f67Zjbtv7QY3wsv37fljt/73NUm740UELA+MQl7mDSGYPT/k1OGwS P8Oj6FqXCNX5dDBFf/UVRTCq791k8vTQ1uT51VBj941OQ9X65bg5f74GQ0Oa2e8/i8nuZbr8OA2P K+eh+ng/ZIAbE360JypBXC536bSKsHF+xFEI8HOMX05tzdNv/uXnaDaax3lkf/wJhxlHma/oVSdC mNGnaU2zWLRqOCu4/LYHJRfdFDOjsk09mh2EZF6ysE2WR45Wy/uJ5CypcV6olvCznbNZJ+ueWkdP QKMDjcwKYSQC3ELpw1NCTMEzFSO4Gjq06JGI4EcJq9OvFXNACGTMaby8cSdsDiJMxSCeE2MOf1kK euvkO8OTBkfUkMY+xaTxZw1KmzK46FhG30FcGSC5Er7TgqxnLYz/XFxFJd8RW9FPT+gNHYfVBZ+m 4m0C1QUkPr89UiE8e/syXIrEULeG7PTk4XTuMnv+aJoabJ7IiB/t4p/MScRVrefvT3up0KfYin6q 9ZS9lh2+iA6oi0OcutIF8yLHnoHABdqTIY2JiP54QNVRYlFjicLN6CqjtSmbnKSvdTs/2osh1qgQ l/k4704FzaGiWqdKV8bWxU+Uf7LtJM+Uvetif3ZAsYBcR9l0dAIbRHyayiTffwz23zPsVhUd3esI k+0p9RGp7Z24w0RfQqINkx/tubW3AOr2hOMiCiSSfEHWlZHH+3unr8vloFj8SIdGC0aIqbaF6gNW gtMgcMxpmqh7IQxBhQXWBVGFLXPdEfCudRILM7yO4Cszk/18XMl+3cAngiqPjfVT5kVhxq3qgrJJ 5SJYJsf3MMXOoEJ4cKijc+B3mtHh6gpodPhv/Ct3bwGihneUgamh+x3BVahjyIDuNGOowp1h+A81 FCdmGVqw9wAAAABJRU5ErkJggk== . 153Two considerations are worth exploring here. First, under the original assumptions of the example, the compensation contract of Bank Alpha’s manager perfectly aligns her preferences with the preferences of the shareholders. See supra Part I.A.2. But in reality, Bank Alpha’s manager may have private reasons to continue to prefer Project III even under the pooling interest rate. See supra text accompanying notes 143–46. Hence, the shareholders need to monitor the manager’s activity in the negotiation with the debtholders. Second, note that because bank assets create a high level of adverse selection, even a single agent’s attempt to distinguish herself would be enough for the principal to conclude that the remaining, non-signaling agents are bad. Thus, if Bank Alpha failed to separate, the debtholders would infer that the manager will undertake Project III with probability 1. Therefore, they would demand an interest rate of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACkAAAAQCAIAAAAEd8HEAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAXFJREFUSEvtVSF2wzAMVXKWtqCvJ3BP0I0MhY4lsCNjg2MjCexYadFIkxM0 J+gLmH0Xz5JtxcmcDvWFTKS2pC/JX1KaaK1hJklnyotpZ8+tqm3iZFupgImmSJKiiVETh6C/FUZ5 xyAMquiqdZ0D5LXpu9ayFO5MJxBCeBPZvUQhRhkLI0pJgekXhf1SUN9XyJ929LjFY4Yp8bS/GLdj Fh2HOGR30IdxGNm1m9XChFtt2k5isKZ4gNr6paiGzy9LrDqfWl/HjSH8E2JSivUyEkFV79fy1VaI nHuu8eZI89wi8yNVaKIAv+09+dREdHCcW4vtp++37wVquS+uplhuE+MGJIxA0+RK5MxuBACNvfMo +cS7JyHhSA2G076D8jArdQrLtWhfPtwimUYBDUdMeOMmIKp67t4ue0Krqhhsq7GdsqO1sbip93em gJvSNzXYLKbSWB1kCGD1aK/698vSztqdZdAj+0HBmpP//5L4gN1R+wPAYHAUgw9LBAAAAABJRU5E rkJggk== , jeopardizing the conclusion of the debt contract. Under this scenario, sending a signal to the debtholders might thus be the only supportable equilibrium for the shareholders to raise debt financing.

Which form will the shareholders’ signal take in a highly leveraged corporation like Bank Alpha? As discussed above, the negotiation of control covenants is the standard signal that firms employ to reduce the costs of debt pricing. 154 See supra text accompanying notes 138–40. Covenants, however, are costly: they may burden firms with high opportunity costs 155 See, e.g., Sepe, supra note 112, at 145–46 (explaining that the rigid structure of debt covenants may deprive firms of the flexibility needed to pursue profitable investment opportunities). and they may burden debtholders with high monitoring costs. 156 See, e.g., Squire, supra note 11, at 1153, 1162 (observing that covenants need monitoring to be effective and, therefore, may be costly). Thus, the posting of costly collateral is an additional signal that firms use to contain increases in interest rates, while simultaneously reducing the costs of covenants. On the other hand, there are circumstances in which the nature of the debtor’s assets may make collateralization an inadequate instrument to protect the debtholders’ interests. 157 See Tirole, supra note 49, at 167. In addition, deadweight losses may be attached to collateralization, including ex ante and ex post transaction costs, the presence of ownership benefits not enjoyed by third parties, the suboptimal maintenance of the pledged asset by the debtor, and high opportunity costs upon financial distress of the debtor. See id. This is especially likely in the banking sector, where assets are highly fungible, because this feature makes it easier to “hide” increased risk taking. 158 See Levine, supra note 93, at 2–3 (pointing out that banks, unlike other types of firms, can quickly alter the composition, and, therefore, the risk, of their assets). Moreover, financial innovation and the development of risk-distribution technologies have hugely increased the ability of banks to “play” with their assets so as to hide actual risk exposures. Cf. Robert P. Bartlett, III, Making Banks Transparent, 66 Vand. L. Rev. 293, 295–96 (2012) (arguing that the opacity of financial institutions was one of the crucial problems of the recent crisis). The venture capital context is another example where collateralization has limited signal value because start-ups depend almost solely on intangible assets like human capital.

Thus, control covenants and collateralization alone might fail to provide credible signals to the debtholders, especially when a firm’s capital structure is highly leveraged. In these circumstances, shareholders will need a “validating signal”: a signal that can corroborate other signals, which would be useless by themselves to differentiate the shareholders’ firm from other firms (i.e., move the mechanism of debt pricing to a separating equilibrium). 159 See Stephen A. Ross, The Determination of Financial Structure: The Incentive-Signalling Approach, 8 Bell J. Econ. 23, 27 (1977) (suggesting that in adverse selection contexts manager liability might be “a means of validating financial signals” which would otherwise be useless to achieve separation). In different contractual contexts, scholars have discussed the benefits of liquidated damage clauses and private antifraud rules as validating signals. See Robert Forsythe et al., Cheap Talk, Fraud, and Adverse Selection in Financial Markets: Some Experimental Evidence, 12 Rev. Fin. Stud. 481, 487 (1999) (arguing that an antifraud rule punishing sellers who make false statements as to the quality of their products constitutes a way to give the “seller a means to credibly communicate its quality”); Lars A. Stole, The Economics of Liquidated Damage Clauses in Contractual Environments with Private Information, 8 J.L. Econ. & Org. 582 (1992) (Eng.) (arguing that liquidated damage clauses may be used to communicate valuable information and move from a pooling to a separating equilibrium). To concretize this idea, consider again the case of venture capital. Two features make venture capital a clear context where the shareholders (i.e., the venture’s founders) need to send a validating signal to their financiers (i.e., the venture capitalists). The first is the inherent limit of collateralization in start-up firms. The second is the high non-common equity financing employed by these firms. 160Venture capitalists’ claims are most commonly structured as preferred shares. See George G. Triantis, Financial Contract Design in the World of Venture Capital, 68 U. Chi. L. Rev. 305, 312 (2001) (book review). However, as observed by Douglas Baird and Robert Rasmussen, “[w]hether the venture capitalist formally fits into the pigeonhole of ‘creditor’ or ‘shareholder’ is something she cares about only if something turns on it.” Baird & Rasmussen, supra note 4, at 1217. Baird and Rasmussen also observed that in Sweden, where venture capitalists do not have the bankruptcy-related concerns of their U.S. counterparts, venture financing often takes the form of debt. See id. at 1217–18. Observation from the practice suggests that these firms adopt special governance arrangements as a validating signal. Compared to other corporations of similar size, start-ups’ boards have fewer executive directors and more independent directors. 161 See Malcolm Baker & Paul A. Gompers, The Determinants of Board Structure at the Initial Public Offering, 46 J.L. & Econ. 569, 570–71 (2003) (gathering data from 1,116 IPO prospectuses and finding that “venture capitalists institute better internal governance mechanisms”). It is also common practice for the venture capitalists to personally choose the venture’s independent directors (with the acquiescence of the firm’s founders) and appoint individuals with whom they have strong personal and professional ties. 162 See Jesse M. Fried & Mira Ganor, Agency Costs of Venture Capitalist Control in Startups, 81 N.Y.U. L. Rev. 967, 971, 988 (2006) (observing that start-ups have unique governance structures). Even more importantly, empirical evidence shows that start-ups’ independent directors play a causal role in the firms’ decision-making processes, acting as a “counterweight to CEO control.” 163 See Baker & Gompers, supra note 162, at 593 (“Venture capitalists appear to be a counterweight to CEO control. Not only do venture capitalists reduce inside representation indirectly by reducing the control of the CEO with their concentrated outside ownership stakes, but reputable venture firms are also directly associated with greater outsider representation on the board.”). This feature of start-ups’ boards is similar to another example of a validating signal: the “use” by private debt borrowers of a bank’s representative on the board of directors. 164 See Randall S. Kroszner & Philip E. Strahan, Bankers on Boards: Monitoring, Conflicts of Interest, and Lender Liability, 62 J. Fin. Econ. 415 (2001). Kroszner and Strahan report that almost a third of large U.S. firms have bankers on board. Id. at 416; see also João A.C. Santos & Adrienne S. Rumble, The American Keiretsu and Universal Banks: Investing, Voting and Sitting on Nonfinancials’ Corporate Boards, 80 J. Fin. Econ. 419, 437 (2006) (finding similarly that about 25% of non-financial S&P 500 firms have a banker on their board of directors). In addition to enabling superior monitoring by the firm’s lenders, affiliated bankers on a board can exert increased control over the borrower’s decision making. 165 See Kroszner & Strahan, supra note 165, at 419 (suggesting that the presence of bank representatives among outside board members reduces information asymmetry between the bank and the debtor); David Erkens et al., Affiliated Bankers on Board and Conservative Accounting 7 (Mar. 2011) (unpublished manuscript), available at http://www.bus.miami.edu/_assets/files/faculty-and-research/conferences-and-seminars/finance-seminars/Subramanyam%20-%20Paper.pdf (“Lender representation on the board increases the scope and dynamics of the firms’ relationship[s] with their lenders by allowing better monitoring and increased control from the affiliated bank.”). Thus, similar to the venture capital context, in private debt, firms employ special governance arrangements to mitigate the potential conflict with their financiers and minimize the cost of debt. 166This view is supported by empirical evidence about the positive correlation between the lower costs of debt capital and key governance features, such as the presence of a banker on board and independent directors on boards or accounting committees. See Ronald C. Anderson et al., Board Characteristics, Accounting Report Integrity, and the Cost of Debt, 37 J. Acct. & Econ. 315, 332–33 (2004) (finding that yield spreads decrease with higher numbers of independent directors on a firm’s board and fully independent audit committees); Daniel T. Byrd & Mark S. Mizruchi, Bankers on the Board and the Debt Ratio of Firms, 11 J. Corp. Fin. 129, 132 (2005) (finding association between bankers on board and lower cost of debt).

Because of banks’ high-leveraged capital structures and the opacity of bank assets, governance theory predicts that bank shareholders would also need to employ a validating signal in negotiating with the debtholders. Drawing on the insights offered by the venture capital and private debt contexts, the next section discusses which form this signal could take.

2. Advocacy

Firms in the venture capital and private debt contexts employ special governance arrangements to make their commitments to sound risk policies credible to debtholders. 167 See supra Part II.C.1. These special governance arrangements share a common feature. They both depart from models with dominant CEOs, whose risk preferences are aligned with those of shareholders through equity-based compensation plans. 168 See supra Part II.A.1. Under those models, CEOs control the corporate decision-making process, that is, the flow of information from lower corporate layers to the board of directors. Indeed, the board’s role is to aggregate information from lower layers and produce decisional outcomes. Risk-liking CEOs occupy the highest position of the information hierarchy, often sitting on the board—a circumstance that enables them to exercise large control over the information aggregation process and the firm’s decisional outcomes. 169 See, e.g., Nestor Report, supra note 53, at 4–5. The Nestor Report observed that the CEO also occupied the position of board chairman at all major U.S. investment banks before the crisis, with the CEO of Lehman Brothers having held his double appointment for eighteen years (from 1990 until the firm’s bankruptcy in 2008). See id. at 4.

In contrast to this CEO-centric model, the governance arrangements of start-up firms and many private debt borrowers provide for debtholders to make some board appointments. 170 See supra notes 163–65 and accompanying text. The rationale for this alternative structure is that placing individuals with divergent risk preferences in top positions of the firm’s information hierarchy fosters contrarian thinking and, therefore, less biased decision making. Research from information theory teaches that individuals acquire and pass along information based on their preferences. 171Augustin Landier et al., Optimal Dissent in Organizations, 76 Rev. Econ. Stud. 761, 769–73, 775 (2009) (Swed.) (providing a formal model that conceptualizes the value of dissent and preference heterogeneity in organizational models and information production). For a description of the interdependence between decision rights and information structures, see Philippe Aghion & Jean Tirole, Formal and Real Authority in Organizations, 105 J. Pol. Econ. 1 (1997). Combining the disparate risk preferences of CEOs and debtholders’ appointees thus results in a process of information aggregation that may only return heterogeneous information. 172 See Landier et al., supra note 172, at 762 (arguing that “dissent fosters the use of objective information in decision making . . . . as it allows individual biases to ‘cancel each other out’”). As a result, directors informed by antagonists will have a broader evidentiary base underlying their decisions. In opposition, a CEO-centric model may only present the board with biased information that favors risk taking.

Organizational theorists and information economists define similar decisional models as advocacy systems. 173The seminal economic contribution on the informational and organizational value of advocacy systems is due to Mathias Dewatripont and Jean Tirole. See Mathias Dewatripont & Jean Tirole, Advocates, 107 J. Pol. Econ. 1 (1999) (providing a formal discussion about the use of such systems in various organizational contexts); see also Paul Milgrom & John Roberts, Relying on the Information of Interested Parties, 17 RAND J. Econ. 18 (1986) (providing a seminal model on decisional mechanisms relying on information provided by interested parties); Hyun Song Shin, Adversarial and Inquisitorial Procedures in Arbitration, 29 RAND J. Econ. 378, 378–80 (1998) (showing that decisional procedures in which “the opposing parties are invited to make their cases” are superior to procedures in which the arbitrator adjudicates “on the basis of the information [he] uncovered” because the former procedures “allocate the burden of proof in an effective manner, thereby extracting the maximal informational content”). The distinguishing feature of such systems is to provide for a decision-making structure that combines an independent decision maker with the competing interaction of individuals who are appointed to be advocates of specific causes. 174 See Dewatripont & Tirole, supra note 174, at 2. For example, most judiciary systems are built on the idea that judges, as impartial decision makers, benefit from the partiality of the defense attorney and the prosecutor who stand in front of them to respectively defend and argue against the defendant’s reasons. 175In the words of Justice Scalia, what defines the adversarial system of justice is “the presence of a judge who does not . . . conduct the factual and legal investigation himself, but instead decides on the basis of facts and arguments pro and con adduced by the parties.” McNeil v. Wisconsin, 501 U.S. 171, 181 n.2 (1991). The American Bar Association’s defense of the adversarial system also provides a suggestive representation of the inherent merits of advocacy in decision making. See Professional Responsibility: Report of the Joint Conference, 44 A.B.A. J. 1159, 1160 (1958) (“[A]ny arbiter who attempts to decide a dispute without the aid of partisan advocacy. . . . must undertake, not only the role of judge, but that of representative for both of the litigants. Each of these roles must be played to the full without being muted by qualifications derived from the others. . . . If it is true that a man in his time must play many parts, it is scarcely given to him to play them all at once.”). An additional example comes from regulatory hearings in which lobbyists advance their own causes and proxy advocates (e.g., the state attorney general and consumer counsels for consumers) defend the interests of comparatively disorganized groups of individuals. 176 See Dewatripont & Tirole, supra note 174, at 2–3; see also Shin, supra note 174, at 378. Economists have re-conceptualized the benefits of these and other advocacy structures by suggesting that the exploitation of rivalry between advocates improves decision-making processes by leading to broader information production and constraining bias.

This analysis suggests the existence of a “sound argument,” i.e., a logical argument following from true premises: in an ideal contracting world, bank shareholders, who want to send a validating signal to their debtholders, would employ advocacy-based governance arrangements. These arrangements would be perceived as safer by debtholders and, therefore, minimize the costs of debt. In a stylized representation, these safe governance arrangements would have two defining features. The first is the appointment of a representative of the debtholders’ interest within the bank. This debtholders’ advocate would operate as a counterweight to the CEO, who, in response to the use of equity-based compensation, would serve as an advocate for risk-liking bank shareholders. Such an organizational model would not necessarily command the appointment of a debtholders’ fiduciary to the bank’s board. Instead, a similar result could be replicated by appointing an insider whose payoff structure is selected to align her risk preferences with the debtholders’ preferences. Consistent with recent international banking recommendations that stress the importance of the chief risk officer (CRO) in ensuring effective bank risk management, 177 See Basel Principles for Governance, supra note 20. Among other issues, in the new Principles for Enhancing Corporate Governance, enacted in 2010, the Basel Committee recommended that the CRO should (i) “[be] an independent senior executive with distinct responsibility for the risk management function”; (ii) “not have any management or financial responsibility in respect of any operational business lines or revenue-generating functions”; and (iii) “have sufficient stature, authority and seniority within the organisation.” See id. at 17–18. the CRO would be a natural candidate for the role of debtholders’ advocate. In practice, this would require compensating the CRO with a payoff schedule that decreases with the level of the bank’s risk taking, i.e., a concave payoff schedule. 178This means that the payoff schedule of the CRO should echo the concave payoff schedule of debtholders. See supra Part I.A.1.

The second defining feature of an advocacy system in banks would be a fully independent board of directors. This would guarantee the impartiality of the board as adjudicator of the competing panel of risk information provided by the CEO and the CRO. Given the natural risk aversion of individuals within corporations, 179Because of the specific investments they make, individuals within a corporation—including board members—tend to be risk averse in the absence of contractual mechanisms that induce different risk preferences. See supra Part I.A.2 (discussing managers’ intrinsic risk aversion). the possibility that board members would exclude the CRO’s evidence in aggregating risk information is negligible. 180To this extent, the organizational features defining the board of directors under the advocacy system envisioned by this Article resemble the “mediating hierarchy” model of the board articulated by Margaret Blair and Lynn Stout in their influential 1999 paper on team production in corporations. See Margaret M. Blair & Lynn A. Stout, A Team Production Theory of Corporate Law, 85 Va. L. Rev. 247, 254 (1999) (suggesting that “directors should not be under direct control of either shareholders or other stakeholders”). However, Blair and Stout viewed the inclusion of creditors among the corporation’s factors of production (i.e., team members) as just “possible.” Id. at 253 (“[B]oards exist . . . to protect the enterprise-specific investments of all the members of the corporate ‘team,’ including shareholders, managers, rank and file employees, and possibly other groups, such as creditors.”). But banks’ primary function is to produce liquidity. Hence, in these organizations, creditors—together with shareholders—are a vital factor of production and, therefore, an essential, rather than possible, governance component. Additionally, in an advocacy system, “there is always someone to blow the whistle on an abusive decision maker.” 181 See Dewatripont & Tirole, supra note 174, at 6. This is because in this system each advocate has the right incentive to raise her voice if she believes that the board has been corrupted and unduly favored her opponent to the detriment of sound decision making.

D. Governance and Insurance

The above analysis has explained that in an undistorted world, debt discipline would induce bank shareholders to actively seek safe governance arrangements, e.g., advocacy models. The ensuing discussion explains why, in the real world, safety nets—deposit insurance and bailouts—give rise to the adoption of governance arrangements that promote rather than constrain risk taking.

1. Moral Hazard of Bank Debtholders

Federal deposit insurance—which guarantees qualified bank deposits in the event of bank failure—is justified by the need to protect depositors and the desire to avoid destabilizing bank runs. 182Milton Friedman and Anna Jacobson Schwartz famously noted that deposit insurance “has succeeded in achieving what had been a major objective of banking reform for at least a century, namely, the prevention of banking panics.” Milton Friedman & Anna Jacobson Schwartz, A Monetary History of the United States 1867–1960, at 440 (1963). An analogous rationale justifies bailout interventions, which provide several forms of government-funded financial support to failing banks. Indeed, given the interconnectedness of the banking sector, the need to maintain financial stability might arise independently from the protection of depositors’ interests at individual banks. In modern banking, this risk has been compounded by banks’ increasing exposure to short-term (and therefore run-prone) liabilities. As the 2007–2008 crisis demonstrated, in this highly leveraged environment runs are no longer undertaken only by depositors, but are also initiated by large, sophisticated debtholders (i.e., interbank creditors). 183The events that took place in the repo market during the crisis provide a vivid example of how bank runs have expanded into other categories of bank debtholders. See supra text accompanying notes 86–91 (discussing the implications of the increased use of repos and other short-term liabilities by modern banks). Short-term debtholders, no matter how sophisticated, choose to run if they expect trouble. 184 See Mathias Dewatripont et al., Balancing the Banks: Global Lessons from the Financial Crisis 4–5 (2010).

But while safety nets protect the integrity of the banking infrastructure against runs, they also create a problem of their own. Shifting the cost of potential bank losses on to taxpayers, these measures make debt capital less expensive for bank shareholders. That is, shareholders’ profit maximization expectations become virtually unconstrained with explicit or implicit governmental insurance of debtholders’ claims. 185When insurance is implicit (i.e., not expressly provided for ex ante, as in the case of deposit insurance), bank debtholders are willing to accept lower interest rates for two reasons. First, they may expect to directly benefit from future rescue intervention by the government. This explains why this distorted set of incentives tends to be more severe in too-big-to-fail financial institutions. See Macey & Holdcroft, supra note 2, at 1371. Second, debtholders indirectly benefit from both explicit and implicit government guarantees that are granted to depositors and fellow debtholders because these guarantees reduce the risk of bank failure. See Squam Lake Report, supra note 66, at 21. As a result, shareholders no longer have incentives to distinguish their banks as sound by actively seeking to implement safe governance arrangements.

A variation of the above example on signaling can better illustrate these dynamics. Imagine that Bank Alpha can be bailed out with probability data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACMAAAAhCAIAAADcc4UFAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAYpJREFUSEvtl0FywjAMRe2ehbBgOIE5ATtu0F2yhE1P0U2y7a436IrcgBMw LEjuklpSbEkmoWU6w0xn7BWOZH1ZehFgh2EwT1kvT1EBkaz0l1Ln6uXq6QpkIjIR/4mIvqma/uGW Bcr7ZmPFqlqOlJisLQ5nocNmeQgd2spafui/c7va+cfl0X/EdSzBLe7RzNbgxb5kg1Ou7tgMD8Qx MwopH9IKXveUZDQdGU6p9OZnhFsVv+pF9CtWzpyv1MC+eT2Y+m0rI8Ry8a3UjcY7z1Rv+k5wH10k +F2km0M56LBYPeegl7hkDFFZFk0aNCqgEsUK3SRARDyZ4o1x5IcTZB3yDclNEpHCqHDTaWkSKWlm UVLpieguJ2PWywV3b7Fcz8OAxtOlm/IQILRfH6bcIRLbXekPeCVgJkJD5Fz9qxmY8q/fRo4EZdRy 7bsH7nMvciY7Ugl9SmuP7MU+6d2dwmoQ5A5LGtijuTBBV5wZM0bJrmI2ZTFSnrb2sf3NKOKpFqi0 +b/GPPw/Wr4BtCbd0PEwIrgAAAAASUVORK5CYIJ= . This means that in the event of default, the debtholders of Bank Alpha will receive the face value of debt with probability , almost as if they had privately insured their credit. 186This can be modeled by observing that in event of default of Bank Alpha the debtholders will be paid back with some probability data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADAAAAAQCAIAAADfzGvmAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAYlJREFUSEvtlSGWgzAQhoGzQAWPE6QnyK5B1a4DCWZdJW4NSHBrq2oKJygn 4FUU7sJOEgibkCxsH6KiY3gtmZlv/pkMZt/3xjOZ9UwwhGUboC7bm9TC6pECq5B577NuIyCgQGkL 3c8xA+KEJIfKCAOnxzm4lgE9t41CUsoqdGKvhCRtasQfEhJjTRqk1nIt0KjqpK2+N9W5QOkn0cqO jkF9uggi2dEVUL8PGn8AEnPxZv5ygBOJSzoy2jWy9TzdvRFe1rf2H4NlVeHZB2lRwCRGdBbEhFBx cPwLYZ7P2w3EjqtpjY7RwnmOu8vJ80FieBqHd1XxxRvr1WC6UeVZmrt6lpelojPU3gzXoc+alya6 Uv1WtszeeZMzhEQ09lojQNASykFa4+MqlJcJ9oMi0VxfVR44X8dfZCN1WVIgpjnM4bolRe8/EwAm CDwlMZgs7BU3tnQmG2eP/zMslSkaCTBEFmPxdOBCwhpC4Ed/zIDkQGUg1zBLtTUQU08p72KZo54E 2nx97Reu2w+M7/tjRFXh0gAAAABJRU5ErkJggk== . Thus, when Bank Alpha raises debt of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABwAAAAhCAIAAABFi1ywAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAYFJREFUSEvtVjGWgjAQHfYsYOHzBHgCpNnKdjss8QB7Axu3hG5bKxvlBOYE PgrhLuwkTJKBxPe2wML3SIPMJH8y///hGXRdB1Ovj6kBJd4MOj2rM6czpxMz8J6Wan/Wwa6agIqX tA/4kZbrmg1umF0pjo/mGNscT/RbeJqyElSF42MjnxhWr5TuTxgkVdopiEctuswiqAEhUHXt/qQD oiIEQnn7ZrZ7OU2KrkjwTu3jjhDLiDETLWMQp0urQtW5BFgtQp1PPrFkea4QNEy3MZSbYH2oR8qH ixWAqJsnhvDUlDvvD1eogRSqf9sgicJJZN0bdXT72DHpiHe2bk0KxBH7KOjXF2xlFdaxt4kRp+SB cmOGIMxv1l23FByWOWxTC1nSFSrMf9FHSLfnEu3lJCDepr00fspRWAStdp7hHGpO+NVhLyD7zrXc 0gq8vHEDMyPSJ2kfWlH3PhoDPoiObkr90YwOBDVzOIoaotlhvUVbiubs2Umr1X9+veQrFbzNX8k/ Ej7mKCcrO2YAAAAASUVORK5CYIJ= to invest in Project I, the equilibrium interest rate ( ) will be determined by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAbAAAAAhCAIAAAA3YWkvAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAACE9JREFUeF7tXD1aIz0MNnuWZIt9OAGcAGioaOlCSZqv25KOBkrS0VLRbDgB 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(Recall that is the interest rate the debtholders would apply for Project I absent insurance and $3.6 is the cost the debtholders bear for monitoring.) 187 See supra Part II.C.1. This shows that the cost of debt decreases when the debtholders are insured, which, in turn, shifts a cost equal to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAREAAAAhCAIAAABx+wjAAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABklJREFUeF7tWz162zwMpr+zOB365ATOCZIunbpmc8Zk+baO2brYY71l7dSl 8QnqE+TJ0PguKiFSJEgC/LEkpwO01JFIEHjxggQgddF1nZJLEBAEqhH4r3qkDBQEBAFAQGJGeCAI tCEgMdOGl4wWBCRmhAOCQBsCEjNteMloQUBiRjggCLQhIDHThpeMFgQkZoQDgkAbAhIzbXjJaEFA YkY4IAi0ISAx04aXjBYEJGaEA4JAGwISM214yWhBQGJGOCAItCHwnjFz3F4tFnf7NoVPH72/Wyyu tkdCADyxVzAAFJxJvzPbfjpqLTNJhHtL7TUDmDP6iDP9vWIGTL1VT133/brFK2bscXtHcj8v6fp7 1z2pWyZMV5s3/V+Jut/3y3Z9GmeMsr1xrWB4PW71I/ECJMLL+98A7NtmNUb1f2ou2OMuMMySJ7gf WLx+TuYYi6IHXfe8Jm5a/OJlIkyxLAJuPNs/rlKAsBH0jPWBe+hi9UnWzGHF2G7wZMEPXVH/VwG3 yO8RK6dF2MZMCla9NcTIWh/RLBwEYpgCBekwX23UMNOtn8ZMP9feNnK8aB8WCfG4iElDiRKKFukf c3CfoEBCzlj1wWD4V6+L149U7VFL4onBCqCmQcmAT5LKKlYgXBa3dN+bE+HpY6beRz3mHIEK3E5j SN/pY2ZwJBbgMY0YFdAEUyCkA+vW1JPEssEiOd+foEC6o0cWuvWcDXqAQS+Jkf6O32ZyWA0JSsTN PPh0WJwzZiZBePKYyfioRCcMacFf9MbS1zOQh7J1xf7nTqnLDy7Nv/6sWbL76Ur31ccLc6xffFyp lz+mxj5ubx/U5n+iVjn++nFQ688VVYwTXMhlGxXQ0pafvqwOP35R7QB6LQ1Qj8/xz4uOkMFgZ7WT VcCKtD0L/r+Rxp8B4fGGDj7iJFF0KnEby9p/ezisekoXewAETUDSEBxKHV7fjOi314ONLRMxT2Q5 DaMi9Zf3X9fq8HDr6vr93c1Orb9WluONCoCqyw+XXu8EZAgptbtZXH17jZ7BvMzEElaE7eO5cgYJ kyM8XmfeR6qeTiV/ITWP28edWn35BEdHMWZS8+A8GS74bc8ciFlzfkBEVjO+lwR77fPlw4VtSd4o nQhFB9/Lo2tZ4n7wCAV82Mc2QqtHn9qH3e6gYwc3SM0h++iiG3aHQ4YBGKvxRDlFAoMbIeqcCAcb uO/0u6Y0/kG/H+B9VEUnBkrOXyZDGHZxnLJR9Ux6L7rjmxc+5Te/fN/BJ/x0bRKKNPNQLwIX7clD W+IBCDUKGHuzVYiDxBuAahB/s1dyg7oABazyNTldTCYtGsbZbLdzeJDiFnueH9nmYgrhyeuZrI8K dArnBsgxTgjLWNc3cySP0E+lpHUwQt9Xp0xDK2mvWThT1blWWZ5cRQXaYkarZdjGdJUCZUpYEbZ7 6PJmhb2Auh5A1D+oX2B6hGeNmchHzM5FeLDkL7xhIX4WczM6hWfqc1T6+1RNQULjUmJin4Q0H3cZ TL3BXrmiokUB1NfIJj3L+ycdNajrgdNcOLNtmmvVTiyt7WWcknm1zCkUY0jUeRFGX2E05Gah5dhH 9XSq4zYuZfpVizHTt8MwY+JeA1JeFzJk6Y87avA7olW/QlBdBMWZxjT8oiVtXg061CgAY0E+T2W9 YPqRBzkcKjfcrChgRdjeQvrGsfW41Y+EWrXo4jLCgSVQzOYu8tOMjI8KdMJr13A79rGeX6pnhpcS +D0dmTxHr+twWz9IJYisPs61++zPLRL+lcmUwhdErALF9zMu+dRrgRZ0SkUrgpVlkoSaLC/Por5S LL5Tz+KWvGXzeM+B8OS5Wc5HWTpFlUXeX0nl2/vFxExQ19pADHziq0D62xriBXdYz2BpIbctPdAK yYcswbPxCoC1QdgnQREuGK9o0aJ3Dvve04CYDiFsL4KfBlBVzASaxMpQ1HE7MGNZojvr4gThyWMm Ni6GmqVTWo1nuU3tl8E5U9jdMo/JrdgrQ3yixjHuRB3qFSD8ydXm9pw5USV6GrH8pPJnEzYK4Rli xho6h48KGE4UM82eeifqEIkhff4Ox+/Eoe1O9TnkNjthjgk0whIzE2HNwTuR+FgMd5oUsql5tDmz 7fMYUYUwTj2LNdh59By5ygJqGrkEAUGgGoG/A0Ws4XeZUqcAAAAASUVORK5CYIJ= onto the government (i.e., taxpayers). 188Analytically, the taxpayers will suffer a cost equal to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAFIAAAAQCAIAAAAK3r+rAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAnxJREFUWEflVjt26jAQFayFpHiHFZgVCBoqt+nsEpp0KeloRGl3aaloYq8g XgGHIvJenNFIiiX5I5mXFDlRA7ZHmns1dz6zhrPVkcSEbLLdgvyVNSeL3Xu2+St0Nc/5VML1aTXD lZZhW8WG1akOM55oVaZjOJyv4lEsBNOAyiP0FjHe+BdY24ZFYmK1v4mjrTfCOCn8XgItisQHGhy6 AMQzRBtUjl7e78tt+gzcFBXOyP7hK7T16ekcc3WsVMnhKq94YEFAQkUkTqg/rsvH8YJEMx6fnzpi myzyXsDRvwd8v9i9sqi6cXyo384k3mhU8nJfoXZ+3+K35Zb6jltsYrI/Ohk5RFsngkyHNie6ToBd Zd/59UNkcve9D6BHBzKNERgKqj4dculqfAHvyLXrp12ml63IedSuzuaBJOC3KrHv3Cc8H87Od0iQ yxZgXA+rGf5BD0I/oYmpFaiPnhvhFH/le5plFKKFErK12oFUXnItcRVi4zGMYKusdU7ydVddosdS uN5q+dJkFJ/CTh60mjs1szXkN4IZC+5GwgdVJWoTuDzuq+RlammkmQYBdbet83YkhSP2rOiW6cSW 6IZisKRBFJEt/IKGy3SgwhqXAkFb50mhI9GXUvfHyK4UNAtV91CR6e+QbX+VXb2Ngdm3dcdXbNyG LD5bGw3W/c3biraFzPiij0XvCWvxqQnCaeX2oKH6OIwr01ZnXBnbbhP3Oxqmbe4tEllqeSGnIV17 +4YXF+5/0JZBCx22RAx8s5T/QgwLzhI1Tyqe6hpk0zF8OZ71OCnAkOZruAzlMQnjDxgjYAFW8Uex R4ypITmIxgxwYfCgaBFoW/cXnV+18xNsjf3k9k3a+wAAAABJRU5ErkJggk== . Importantly, this cost increases with the risk of the project. Indeed, with insurance, the interest rate applicable to Project III becomes: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAXwAAAAhCAIAAABV4ocAAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAB01JREFUeF7tXD1WGz0Ulb+1mBQ5rMCsANJQpaUzJTRfl5IujV3ijpaKJrCC eAUcith7cfQkjUY/TxpppJHjw5sKezTSe/dd3dFcjZkdDgdGByFACBACrRD4r9VANA4hQAgQAoAA iQ7xgBAgBJoiQKLTFG4ajBAgBEh0iAOEACHQFAESnaZw02CEACFAokMcIAQIgaYIkOg0hZsGIwQI ARId4gAhQAg0RYBEpyncNBghQAiQ6BAHCAFCoCkCJDpN4abBCAFCgESHOEAIEAJNESDRaQo3DUYI EAIkOsQBQoAQaIpAe9F5u511x8V63ye7X1/Mbt/qJw/9TtLxcKiQqpWjukSEpI4pUh6OrFKLxtiG 8GSsNak4fo1zNyt2JF5Vm6G46OzXt6YeOBSNn03h82K14//H5/D7bp7SenwbgOmGPR0Oj5fjOxl/ 5eXj4fDEbjzNm9/9hvR3q8X4vouuLK+gnHSjsR0XQAhPiUUrUinBGZ17UeXExf8sr1JTC7BfVXD4 rDF1lq/Q3Dhel4yhXxq9i+bQ0DjMa6yZ6XVmTVznLFzpDqSDi5500ij9GBpLpOanVDic6NXOG1E3 s0F/Oq2CSi9dbJ1RgkW0JEIkmxkAgicQqAmpArnLmrUkVWS4KXhVdYYyXfQg+6M59Lri1R2VHCkw HuX5FzAMj8EcTZJRByYS97is+nLaynHQnDR+QUUypr2KqoIQ+KMlkSMzADV/EdEJ1Te/ggi2LvoS Yz1kZQr5s7sVqdQN0scyi1RKMMrvN7jKJfEqg9HdbazaDC0UHXNm27M8OFkcfmiE9AW8gSyHJzKO YDk9Wc0DwHcxIssBvAqZcz5USpQdSeTICkCkt/Tu+rGBRlTQ7w6BM6UaepXbTb9ECvlrijak6hZl jlpkk6qa6OBrqyRepYtO/RlabiQvvp7JBfPZ1wV7/yOt4f365p6t/h/lpPAnVmHB7P+88zVR17se Yvv8S47x9rJh7PyLtoUur/ls27wIL3r/63nLltfe+PA0XN/fUTam9ITVB9tAnn/7vtCBpz755rZ7 u716X+0er3Ovy6xgCFt/WLt44bAyA+AdZeNZg1QhXk1Dqp5Kx+aVV7hSMMtFZ/uxk1HtPrZKA6Tk PCXZxEAftrmaXfz8cJKbfzlnTPfuZY5oErSRsgexpFI+d47a7cFPfbkWt5zNy7r/YKghXADJhHMp C0FeLSQnDXNnuMwKItjO734s2fb+Ru8+8GA2bPkjiQFGkdMpFMdzGlJ9Tl4Jga87Q3vReX/Q+7jI Nm/gLKxu1OICFh5ybfH2836bTDgGWzl8gbrdbLY8NXMHWS5dHjSTQcu2kfkJwTQ/IPxu7bR55jtl /IP5nRlQtw6cIMhhyZmugpAO3O1fz+/P1IsAV4w/IDtLyvoBhPE8cVLBXWoKXhlvFuh3Nsw/sPc7 ZCh1Z6hnu0tP0LV6u8/+2d7X7p0Y+ZcyNZ3esI2G4BZG34XoZWVYyb6P0H8z+FQb8XQcn94TCNx+ DmWlH52RBhHfKSZLuCPdf9uNxLvvzAfTUiqtIB61Dag3Rs0AJKQ2ni1IFXB0enMkbhQenVfpLk6g ZT8ZDVNrzAwVRrJzxMEbPuuKTzI/1B5WcB/ZGtqPw/AuhzQgnkT+7pU5qfCSpYuOfX2CkRymM74/ UljBUCaWGEouBvZnCgPIE516pPKkLmveZJe1uxPHN1nH8mqEBPGy1QET83TiZkrsrOEf909bDB6T Uv2M+d2TcEewV5OFg7n4/k1ax3gcbYwcdyEiInNcHGSxMtxi1IMXPNoYh0FD3DOvX0HwYuz8xRih o1YAqXieJqk4erV5Ne7xyi5jBTBBdHgo9g8SrG2j+FkrIG7moP6xua/lEpF37/8SAJUOsIpMc1JY OIY8mbtZcC5V50ZNdPuiYd8abO/jCOJQfbMriGArSmE5LJbNPwGF4nhOQyqO1Inzyrk9easd9CcC 9cFUKx1j50HatZYRHD/bsRZ2LML+ceSuZNnHIC16NaMnBOwR8d5fTXNSbJloo3m/fthw10ft0kvH HV0vVdAYb6EDKh297cIty89qglDUmwZuzzUriGArvrJ2r+AGYSZcMwC1BIjjOQGpYHn9OXlVG0z9 gNzzNP4+eeAR036vSz3+uu6O7wCqhsYkcfpXRlXowdbwM5wmXkAiU8v3UqPG3gxNsFSsl6jxR2Xc 8hm0u7uAM15d7fEw4bBdn9IKBt72tgZBihEmmAItmULDbyS7P6ypRSqL17rWuaRSPBwq6zA/CniV 4+k4pmExmJiRnBOPwRePy+6+lmwb2WhI+V1CenDD5m56X0UtQ4EMk6po2LyL0bLgFVRzpm61cF6g ASB4NiPVNLnnlapr3ZpX0kgeF6t1VSXRyYjkk/Ejoiz/lOhkVFA2PZKm46C1JNXxcjdrdARenbjo qJV2Hd0cmC5HnNrDb49M8CvzbPUouKAxtuEXIcJP2QXZxS9tnLsZzKnzasaTmcTPpE4JAUKAEMAQ +AtQ4/vWyhTjcwAAAABJRU5ErkJggk== ,data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAQAAAAhCAIAAABx8p2sAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAABhJREFUKFNj/P//PwMMMMFZQMYoZ9CFAQA1RAM/I+ukFQAAAABJRU5ErkJg gk== from which data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAKAAAAAhCAIAAADRQTcHAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA3ZJREFUaEPtWj162zAMlXuWuEO+nkA5QTr1Bt3sMVm6+QZd5NFjLxGfoDmB Pw+x76KSAv8AgiSktOlnfvQUSRSI9x7wCCdZjePYtU+9DHyqF1pDphloAldeB03gJnDlDFQOr3Vw E7hyBiqH1zq4CVw5A5XDax3cBK6cgcrhtQ5uAlfOQOXwWgc3gStnoHJ4rYObwJUzUDm8j+jg6/5h FX8e9leW2+M2WMsvmgKSR36T7ZHE1RGjm39DVwKM3UOvSUG1OWTi5NiQQVb/0fGvPy+bbvMSbHIZ +g7fsQ/Vyq7rhwtcT1fxwun1YJldCnvol1wE/GgJThUORXMxIAuPi0kWbtFUSRaZOHk29FMB5G4J 6ve9k9ZXqxPSScE7vTZERQ8WFPa86xCouqS5c2VEixRLP+lh97JZTGH4EpmiMc9dnCwbUsjaoo0N gMOYi5KrLHe448/n13748chFeDyMv5/u3JO7z18it/16Gi6Hb/HL/f0abq7v++70BvZ/3X9/7hJ7 JREAA+vzTgsQpiPA7LJQSMYDi1EQRZWERlNiQwYZKhy6avAXi6pe0B2likYhUE+A/UIzUB/my1nv lWmeKFtjqcJXsIHCeRKzVsYri2NPLLeDFLKxaDCkIjR3qiTKsBggY88R33Rt4FhU4GApPppkdWrs eL6Xh3zwW5UF9tMGkJpImbIhhWwEjkYTQTMuWJIocy4SaT98adNVd8NDL2TIC23lSxUwPrTFqLB0 qQ4pCyyKw5qRLy8/bMFPAWQQeK6ZiVnAC8VlFDV62jrSjUNRp3df0MGxcNxEyA5RiBNJHJnt6VUc ZCe4xM3eZdHlYjbQyy1VqJSgXtPDZlykc85gxotYeyqBLscps0FaFEOeftFxOb/C3Fb66Nkw98nN nHp67ja7YEhmd1Pf3qdB2U6gx+3sgV7t1A2/4o3C+Toxw2twu/Naj9H5X43oWG5Yh4n97WSm3xKL 4fNCHCkbacjaomUWsNCW7WuppsMlHJ0VwWTlE8i2Ba748MqbmACLse3k2EgPXTIM2x24VBHkXBwZ G/SrP4asBP6v+uKvF+wRQDn2ixj2I0NbMlUH+rMFFhata0eSjJ9zfMOaUzCyZQTbxxGxQeU136f8 aSwo5ttZwtoEHTZvB44k0xLklQoy58xoa2+MgY/4a9KNUVJXuk3guvSM0PwBM1KvF6Z4iD8AAAAA SUVORK5CYIJ= (with data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADoAAAAhCAIAAAAHyC8nAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAflJREFUWEftVzFywjAQFHkLUDC8wLyAVPwgnV1Ck1ekMSXp8oNU+AXhBQwF 9l8cnWTp7iQheTLjzDAjNbEta2992l2RWd/34nnGy/NQBaaZ7pT7lbubu2s7kMWQxZDFMKUGcndz d/0O5NydUhWmu91xMyOjagJF4Z3NsYvSieM0FalBoXCZVxnW4EP530RbF5JCeZaXapxLYIT39pF8 WtStec37G8dRqHY5qwE3uhxcsRI4pcqJgS2nocAMX7NCsYnQDcxTHHlNF5Nvo5Q4PXiJte2x1YrV Qm/79tT3p+2fFWlwJMzPfm5h5ss1gbTFFqtCXO9acN3x7SDqd1ba7j5+Oustbnmqu4OKkjhEcagA dyv1pnt7KcVABas/mPXf8k3TReHHcOAthWXKkBuuYp+HosuJaFX5Ik3THYcTapx2HrYKaWs2MIBR 0GquxXWDU3T9+SAOa2w4ZdBhbmZIq7W3ixDrJbpAcBuMNdkonKZaHNbnqHWJw5rvT1HulNe2u1Jc bpIumNG6UVvyfpW9N8kwlm4aRx4Gr9e6tTHTVIFTp/mQcfBFMmSorzIDtOuKlQd61GosRBI4ntWd JLZHFD+wqCFLkwyodd9mqHZs9ADiZd5jHDZjgBxDO2eYjkaadjbIHh6t/zfhncA8GIH2DA7i5xn5 9+6Ue/ULlMHF7glc4TMAAAAASUVORK5CYIJ= being the interest rate applicable to Project III absent insurance). 189 See supra text accompanying note 130. Therefore, under Project III the cost shifted to the taxpayers increases to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAASQAAAAhCAIAAAD/IUG8AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABxBJREFUeF7tWzt220oMpbIWOUWOVyCvwEnjKq07qbSbdCnTpbFLu3ObKk2s FUQr8HERay96MxzOB7/hDEVSfueATWxyOAAuLjAAzCwOh0OjlyKgCEyPwIfpRagERUARsAhosCkP FIGZENBgmwloFaMIaLApBxSBmRDQYJsJaBWjCGiwKQcUgZkQ0GCbCWgVowhosCkHFIGZENBgmwlo FaMIaLApBxSBmRDQYJsJaBWjCGiwKQcUgZkQ0GCbCWgVowhosCkHFIGZEDhlsO3vLxaLzXYmS5vt ZrG4uN8z4uyT7gILrIIT6Tez7XNhnJPD4t/i0F0TQD2hBwdAOiTY9vcblrM14i0K183T4fBwWfOa WztMgcuHw+GpuRbie3X3Zv5r3+HvzbJen8o3jrK9UtY7Ws7iv7z5a2F/u1u9I00nU8Wamlyt1R3x utsMEOmC+Hj9jDZ7XjcNudlBC2UQuNPXxlXA7oaEWz2xPvZecon6UPtSdfmnWJaDjVEM4Vn3K09g XvbhAOyVFrmgOM77rJntvhxV6kwGqzMerDDWcEDWC0DM0j9QyILW0FBjg00SGOOJMFYKtdavYD+n c7zlsAi/Zz0xQAHibqy6p5T912iRykeqtpqSQOzYiM2yUPOgBOeLLKcpsZeaZlOKMvtWKz6IRujj TJzSYwD4fFYZO9gyHoTGOh8R2DnXccdSRBgxgYU0DbYWujXJ8jkgUu5AHnVEpZmJbsecpkD1kRWg ZwgKtiAv2BB4S4KrjZ7oK7QTXs5Z4mFjUBDTughu5iDIoGhUoKcVX6cAegzwvnCGjxxsGQ9ah/UY W+SJHiawUmLPtt18frl7e7iqLVhXn87cK2efVs3LPzeA2N9f3zZ335h+bP/n165ZXxV0amHjHo0q FTC7Lb98Xe1+/eFmJbws0260veX+34sJLW9wsDrstf392DTnH0Pbd3llQvHxt58BsbbbVmZI41rp p+3P292K9UjTGBXSXnX58ZxuLtCjHvwh+Ffayiz3HiTGvr3uzBGT8NFSd7d+7mne+5jAQuqDrcXy ach0YPf65oyzajuiuVDjd7OrUBgtb76vm93tdZi6GGUem/X3Qm0qFbCqWjqF14hrbCw2j58XFz9f 0bOWhvKLjAfsBj4DtQiVppDj+ZXusL//8disvn4pmv60KQPmQ5EeA8Dvxf9402UPgr3tpMqeMGmy s0mp4DDoYQI2wUHqysjk0MP9Sze6WK3CuIgcwq7ggPW72FHQ/bvSJ/QtRlH4tjvWx1LAGywXf2GF gwwoA2txP0VLmzRQ/8OKRLTdz0do88DXhbVlZE2VxqyV6JEsLfS+NwcjISuY0oKLQrnLjW9SMia7 wg266tD1bO4SJGSZQFtsSyMTbHBe4GEwd72O6QLaUGKbIuxR46gvjyrkJJExpgIOhmynFZCKBiTu Sv1gHHGXjEhosQ/u5Cmf7xSGc66ztnDWB8ngkwBtSj096rwfkC0PtkwXWvCI9SAd+cBZXBpgbgP+ 6MgwIVUtQtrAmS/IHRkR2dkwd9KBWRd6W+CoRI88K2PSh8mWJjBxrJEGm1mUwxvOwqlmsI0+0cmW FYtpgVGXo5yhRxn4JNl11VPvfLUgutASo1CfB8EJxXCLTkLkakMYa3rDPtjuOL0Sz/Bte65aTeYi tkrt6n47JpAbHdfspWMF11OJ11gKJIOMbJewvHky6S2OOUAvZMc9oRfiNTtNlxa0LG7Xtpuz2/Nn PKypoEel98vwT77uCZ+apD/w3wRBh+Y82M71clf7PLTd4sp2+IW7YgRp/xckxlr4DROdyHkNTHPJ zkXSOaX9GUUeNQdMGkZWwCpr95djwAikXw6xy103HSc5rSVJWKLpJGP78cOAnh2wisJyMytoh9F+ SrzdlLAYbFbi/e6FPP5gVxTs5FRhp4YZD9qhCDANpHomXdKjgIOQgZlCCv+o7ach7tOl2N7E4zFT U8WyzXdFadOX+xM1btJg7wl/O16B3r+zhcLBFSGowfO48IqkygrlsVAt5atj2nGXFV1SCQmLI9Kp JSMRIFlWstD77W58Y1jYVZbUkhkPIrcRg9BzQD6homSZwEEKgy0W6GmLA8v2zHCGzO1w9xbDt//b lgTUkRVgcQBmoUaF6zHFKVXaBFOsICcD9XCy7Imk2Bv1UE9s1wBv2L6M8TNPD5xaW5Vgw0ynyxyk ZemjJNjQ12fIV9BcKhUMPtIUQIKtW5mFKnVtme59q1inRqOQQTSz9e3f+7xcAUa4RMnuZOsVXrNg AttrxE+ythx89ljrbo54sgUrp/DgcAhxGTl8p7o3T8S5NhWxpyp3YE/kqhPZXuegaVbz+E89jZzG lvpdTxVsvnSfIp0JKIglVb7wq8e05A2JdSXv/k/XsPinJduYZeS7xGhhtJp8IqYCFAFFoGn+A+gW w4LcYES2AAAAAElFTkSuQmCC . 190Analytically, the taxpayers will suffer a cost equal to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAIAAAAAQCAIAAABROuDfAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA5NJREFUWEfVWD2WqjAUjm8tOMUcVoArQBsqWzsotZnO0s4GS+xsp7J5sIJx BR6Lwb3w7r1JgCQgARznvFQBkvv73T8mRVEwWPfDbMVOX2uH7/dsydgiocdXrboIr+L5+3z+cBGy /YYtF8LczvorWbxeNGe9dTf77PWMf5Ujd0B2PobbH4Z7Fk0mEZrX3EgL+EF4PFt7ACJmQouodi08 PTvcu44N/f5Au/KTwDrYAZcUBlJQkYbMi3Pc8ZXHHh1WXlafrXZAky9JJA3FztwojMPUij5JqQpY stSFR32Uo3jSmo+VOB3a6RaunjEC7t9X5r7V0j3kIOLKS0LTAq8+wh18njMyZB4znlaACedhbioG zmLpXb+HwtT/AEMLuyLfKQfZ/bD6XOZCFx42uytHWPvqUFC/2KWdn+TLz1VTAKID8tvFe58ODT7z 3v2wO4Zp4ssQINr5zQ3ojblRKVxu+QhRpCLO+hR7ROr+97Mqb4xj6wQtxlNXt3aALQFFlTE4wAiA saKBQ0Nu7CyablwsLugTgra5Ubg5by7TQgBTqLZacjmY+qJEMpIyX45Uj+TB8KcNiWKlXUt0iy5o pFDKdajogEOK9XNQFBQJCDxKAuamKxUADcjhlFlk1m9JjZXjJU3VHU9QErQ6ByDGdTcD5WBDHKy1 a4juBgdocKuJXYFxfmTHuTyoAhICyoOOFoVK2Xxs4+EniQ8gpvSlJhPDnNzx8jUiv3di7VQQO3Qf HH1xt4Asehrp1gYHaFW/xsBP5Deo4lUXoQISxJPAm77zNDxy5TcmyoiWYRS6wvHiHQw2l/6dtZWC yCj+EIbPoj4Qa0CEcMDw1kM3bg2HaITeIDSdBRTJozisBH4WtbRfNcdjEybbgHGNVQN01KLiJ+2t onq5pRiBA7DwPW0hPNzbirITGsFWPCGA2RBkEZChkg7xBGnvHDRFPeTmWlakFlge09oPqk3TzYWn UKsZTjVOrdIgLaRANKMDdbjlrFmbtZAA5s8ybuoUxdzVcyxRUlA9Z5UDidX4YhzSB5ZHVIxBrPUw DmLPUlBhkoa8OchTPurJbsGwgi5rpSeTk29PAVuUlRIMM7853HY4gCPJSnQcfsdM9k2S5HEofiAI iwuHCFCXk7/CWc7r4is5QFO8HOmtNKtLZg/KRsuOvD7Q68OvkaHQSMIT9AvHi2PxF8bKfNwB9DtI P1+5c7iIvW7+b/bvpVzb4X/gT61adj8FrgAAAABJRU5ErkJggk== .

Now, assume that the debtholders, as above, expect Bank Alpha to stick to Project I with probability data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAB0AAAAhCAIAAACqSTeOAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAR5JREFUSEvtVrsRgzAMlTNLLlUmgBHSZwTSZo80YRnYgBHSwC6O5V9kIwEp uEvu7ILCkh7PT08+K6017LAOO2AiZMF1whYdig50xIofftAP/U2pup0Wr0Jz/367ugag6ZarwIcx N67qOcpV47MCPgEjIYS4FjOm2qhQ6ZNZsq4uw6UEXAJ/UBvjQlabxnw8UtCBnNvSl2E5DUwJbmMl j0slmkssNMyjOkFzXNI4oW1CwyIqjxvYefnnOrCw6Wbgi7uMoVJ/ECPOfpa4Mx0TBpcRWTYtrSf6 mntyaut0KsfXAHA+HT8E+sd9qK4XsrP6nNE68yvDdsvgGt75vPmJixQyGbdp4KbWLvQT17dU8o1k sz6t4YqDu3IJqj97p74BxxPfR7+P4QEAAAAASUVORK5CYIJ= and to switch to Project III with probability . Under this assumption, the breakeven interest rate becomes: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAASkAAAAhCAIAAAAK38oMAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABfRJREFUeF7tW7FaGzEMvvAswMDHE4QnoCxMrN3CWJZuHbuxJCNsXZlYIE9Q noCPgeRdUvt857NsyZadw1f4dFO52Jb065csKelst9s18ggCgkB1BA6qSxSBgoAgoBGQ2BMeCALT ICCxNw3uIlUQkNgTDggC0yAgsTcN7iJVEJDYEw4IAtMgILE3De4iVRCQ2BMOCALTICCxNw3uIlUQ kNgTDggC0yAgsTcN7iJVEJDYEw4IAtMgILE3De4iVRCQ2BMOCALTIFA79rars9nsel1m7Pp6Njtb bWObGUvKZE+266MRU4Z9PdAm81aWYPX/92o9m+W8mS83xeKeF02zeE5v13LSCzfLBUcX5rK0ViUr aiGmdOOBVmLE/71nQv82tZAhaKTjyT7RwCQOaDkTbAwXt+vgg4lLLBs+DpIANzOwAY8GHicq6TVM 0BAwFIKol3h+xOTWhLRLMWkaGCcB+1GHU9RlGVUr9jBmtv6ynjTqkuGHU7uzEdnlE4+Z16PLBh30 v4DQnMjTMtL3N3mipXmihiAPYIOmTgB6EuBAPxr1MPswuSNBmpXQGOD3cWfNaK0ajIpTl2lUndjD naZUdOljXIOTkjygWSz8MOj84AXfCLHnkhkSmxdNPUE4qyM01wjhF5fLQNLeVnMmaJDS1JE8P6Jy x4J09NjzYk2dD9Jt1GSuUXrWoltt9ZgJSPdHYqSR1VI226eHl2Zxee7tOr/b/f1xaF9u3l4UK4JV +nN9wHz5Ex6wvv72utzcXRK6HF5czV8enqKTmTwz9LV8cmT2HJ3Mm9d3c/h29f2m8bXLPhpsIBBr FGS7Ox9HTBSKWOveYtDWtzehE7Rsz4+Hx6ehRrTcWpBmOWT7/uo423rc8ilFXZZRB2ru+HjZ5tH7 x9Xwx+nxEBRZWmOLdVRZbdDT9DBPkwInlvb64pcTpj2J/sB38GjNgZe3zd7auwfY87RJBiMTeVFN 8lVIIxY/E0NsP9C2q9/3zfzqIk2L9eO9n0PbyCMgqgVplhPa/MEjD0pdnlFuV5kcQoKOGjGGOCDo jpwSwTmS2I2NDJw7nz4cfGKqtLkduESEUcucmgtW9OnmDdREjJozhpidApDuIoYs+aANajNLdnRe GpFbDmkhFZk0MCWm0xJRvWoXBMAVXKO6fi/la3Y9jS1k+a0zLqRxSCT4plddvfU2Q6PcXUYYyt34 ssHjRtYQg53++LG5REkiFu330NArA613Z9j+4IwocFYhpKWMZNLAn3LOl0s4bXHkI9RlGWVij0iU pfb5+5iR7aUac4rbuA5v8AIiGnvI3CB5zydmGsMFBu/BxLkffO+FiHUwloPGcyCWMeisQw/V/LTG k15E1mgOC4qV+BSe/pTiia1gOIVTbv7utGeChwDBSArxmpO0ipnJI8sc3Vy6o9SvV3MyEPOHdkA5 RH0eQdN2R+X6d0AK0kIqYtcC5zuHBAaxj0metL8pY3f2eswWe9yxpZNl9VAwbFx1kwrGqe2gEwx5 2tEap79HR31qVmUnPGp8C2Qhgyx9BnNZu/QWH7G4E9Cs/t5djCPGOG4vxPTkyAXNyNNHNv6oy1NF +bKdn/Yj2PV1yaA8B9IyKmb4F1joYcCgrt1OG6VrzmR3UXSdu5tQCaZMthcTkjo4qZTMOGGD43+P j3xxCsteT0PXIqia+1e6okyvSPqEspqDWO9x6mc93nuqrnAqguCuVZ+RzTRZmu0DKZehUf8SNQ7C gjR1e4ViRqnY+/jQQ9u2vpkb8otXH3Kqp6Hy8H2N8cFJZcGPUvokAGuZyOAWaAv7vUT5zok9rNG1 7YF36YD0le5hzQivfZKgeV8p+9nHgIaWf4getFyMIFmQcmPPV5akgS2B8eGZfw7h8SAVQqP4Wu+3 khNJqcaDr0G2NP7RBB0HYnEaZ464bBuYlx4pO1sgxwreGvRyHR9SnjJjrUoZVec3ZcaaHN/ucxnv s3cs3Mc5pxZiVRqPcSD5QqfUjD1bM411MyB+oLqTz+uyCpnk64H2Kdw9U1oyxmeyRBAQBEZG4B+O 2DP6bFfSzAAAAABJRU5ErkJggk== . This shows that when debtholders are insured, they are less sensitive to increased risk taking, which weakens the disciplinary effects of debt. 191Consistent with this simple example, spreads applied to U.S. banks did not increase before the crisis. Rajan, supra note 1, at 148 (“Bank debt spreads . . . remained very moderate until just before the crisis.”). Indeed, bank debtholders fully anticipated a bailout and the rescue of Bear Stearns confirmed their expectations, making them confident that the government would intervene again. In this environment, it is unsurprising that the remaining big banks, including Lehman, did very little to reduce their risk exposures. Significantly, spreads for credit default protection against a Lehman bond default were static until shortly before Lehman filed for bankruptcy. See Skeel, supra note 1, at 24, 28. Indeed, in the above example (i.e., without insurance), the shareholders expected to receive data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACoAAAAhCAIAAAAgZq7PAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAYFJREFUWEftV7txwzAMpTKL5MKnCeQJkkGkMhlFLpMuG6SSNvAEPhehd5EB iqTAD6jLXS4sQjW2DOI94OEJtqtlWUS+6ykfNTIX+oz6F/GL+JkUKNbLJHxZutR69/OpGuY/HUVm 5wv4uYHX1Dtd95P+3A91o9wi3Ds5dgqNongUGgfp1Wm4x1fIULc6U1VlKdcaXVCvhJU5OMLhAL2l 0/Sqzo2e9suAmxJMH6EqgBjFidLz8qoumPapansDMjhWfNC475X4iSvFnor5kPZsaD2+gGR7GtG4 Dk3C2ZTgGHqsb0uNlYBR3vcm155gbeLgePTa/8F8d+cacV1sGj5OuHbq10/o8+OLrL95aN7aaXl/ /tFGbI7wDF6/71tSiAP08xBZtd2x0Wmwil+uo7Tc83A6E0h9qj60QlxukhQobxch2kOdxNHbCKcN yuDoUDRnhM7EyRPsqusN2100ylcRHDV7b+OSY15kbcTEg+FS27v24XBC6+1tjF+NZ/7Gq/71H+wH vCcgzx2jRT8AAAAASUVORK5CYIJ= under the pooling interest rate. Instead, with debt insurance, they expect to receive: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAASQAAAAhCAIAAAD/IUG8AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABo5JREFUeF7tWzF62zoMlnMWu0O/nMA5QdqlU9Zs8Zgsb3tjti722GxZM3Vp fIL6BPky1L6LHylKJEgCICVKbF8/aIltkQTw4wcFQMzifD43cgkCgsD8CFzML0IkCAKCgEZAgk14 IAhUQkCCrRLQIkYQkGATDggClRCQYKsEtIgRBCTYhAOCQCUEJNgqAS1iBAEJNuGAIFAJAQm2SkCL GEFAgk04IAhUQkCCrRLQIkYQkGATDggClRCQYKsEtIgRBCTYhAOCQCUE6gfbfrPor6vdyZl52l0t NvtKZheLmVFbvfT/CIliKNUCmhMeGfSiLQ7dNQMxZvQgBUn9YNOarLdH9X9055/3yylc9RetoRlw 2zyfz9+u61p12m3gzldXeHP97Xx+bm79PWZ5/1OT5LhdV9ZmPnHantCku9fuV/sHWhzcdbeiaa93 TYP+2AWbXV4PBBcuP5ykZ3sTgwGMzqF5w74z2nrMGARj5wPMSEM4/M4wzVF/dsDT6/NG5bkgixuo ma30GMqRhptpjAc5c3i++Rph6zQ20Kw97TBoXWtu5wsDvLvr4kl/8hyGhprRF47rV9d/1boRtlZr NELtj2aYVYzTucRPjLYBNINg7BkQk4o0n7CigzFhYzaDeaNa5awLzFjnpuHcwHaVbFUz3cp40Dcn YJSJUIpvnnBqpAq2iBVBPATR4Q2HAeUHF+n0YDmLpZ2gBvSc65eEoQMfh1HQ9jM5nTOdgg5jtC2B sd/xglhjza8SbAmj1G3SBS2LQke6NIp4VsUPt4mDjeMba462hzY2DDZ05EVz+vWmAvbjCqRxq4/r 5vDyw3Qv9t+fmubyg62urr8oEJ++21aGnapnvf0yk06724dm+8+owkMl8H3FonN5snpRN2HRt/xw aU1I6TxhVt5rWwjj6cfLobn74gPGmj+hDeRSKaMCFxzfDyq+gBHDubH8fLO21KthYqMLxo5jDKOU KvxdqCs18qJpSXp4PxKWIXjrkX1UgakaahOUJtSes9ofGt3m6dPi6ut7GbZtgBlPJ3UeLYnWthBG DZ6/443WccKJCaOgJN3a+fSmGl9wc7S0yueGFkmzsdy2AXwDjELk8nfhBDtSdSPNo+rRNqN0qKgd irz0E6y/9OfuKaeXNFzff3043P2bFWpqtG46qSf04enpoIJubI/3tHtU4l+pxyDUuchhtLYlMBap NHry26PtrUd9927RHKPMu5xVxJkCbritnDMOvESy7wjgB9yoXL7xjErwDagNR7bJptdvWm+3oEUS l0vBL7aC7xJ0l6q7VWEGGzVSunTXjSa6eEw7Lsj0kzp3Ip3quE8TEs0koO14GPnCBC1ZYe3Kxhtq BUQsbGz41SBjFDoQem8oN/o+UVTxTNyN9DmPLR7XjtBY/i45Uncjw8vzbezouGgGC7i+CNWLYoJN YRx0v2AgUtSPiTpQ5zEdEyWC1BZTOqUShYrbCzNb/2RjirOSj+aQPPRbCL8Nh/HKEJvpU+Ld6nmC jfJgxtaXpVC4DvJSu63V1zefTUsET9uJ8gL0RVxW2eapuWn48v5ZNZBB/yWVJO03q4fLV7+NMkjn lADuPqdtAYwlKo2am12b+UZFsrhsfQg3QD+OsWdcGukviHgQY5SbxN/1SrWImXGw6YqrASVXCyBg f9jpA+urqWhfBPYpQ/AUYnGdltsqUFW5LsptpbbfmDx9gM7DyJmv7UAY2wYw2aUapmR6tDLDPyoX d6TRRQKjdFPEW6dtR+KRkssN3dzKdL9u1nIXekAp4UGKUQYO/i6EDB/paYsncTA5YBIO/z0b/Oal NtQrMJOYRVkEk0dFmTN4E5Kp89AM0qbQnLZdCRxmGrxKXOqSn+WZ8juZ4/jpXuB1okxAuBH8VM4N 7KwMn9MNdaB7q4x5kGMUolvIN+9IRXjAQ33va7auDKYKA9BKIIb4oRbl5f6Zk+ikCdgUvHtedd4N gi9Ko/0XzE7rPNhTnVmUtrbTNArGCEH8XGAikrKCLTywFPsjOkEUHA/qofN7TIRu2dyocYIkPKuF M8a5ODgzEjCuv+vtUGjjDQTbGN6BOWh9H/aizHi+QVKoR7Xp3b44qbxoX5109d+2WD43UAAmfrJZ GObwYALjiU796/Q5SpFdTl37DHu6avkTR6g3QMeblxX1zutPVDlHp0xuqCpHt7r+6v8Eqb7hzZPd VTdjPoFzbeXzaVy8MvrwgyVEsgotVqHGAgslJGd7kjGCgCBQiMB/2NJ7FIRVwhAAAAAASUVORK5C YIJ= . Under these changed circumstances, it is unlikely that the cost of signaling will be lower than the net gain the shareholders obtain under the original interest rate (i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACcAAAAhCAIAAADVmCV/AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAXtJREFUWEftVrt1wzAMpDJLlMIvE9ATuPMG6agybrJBujRiGXfZIJW0gSfw c2FxF4UAHn/6UCoYuSEqSoRwxN0RT0Xf92zzeNocEQAz6n/TnhnODKdjILspHZfTlTLDj2FYyUqq VdDrM/1yqKuS+yKI8nSdxlzIdNtVOyjQVkXhXup/ib6rOWOigeVCRDMbYarAitedK+a28F1CD7e/ ZyaOB+jxcBTscutMu0p+nkXzjVsYCVF1Nb4rqWy54+x6J2so+XZi9YfDTI1q++tuF/b68mwxf95h 7cLqyrkWlyKQJFAadZ3J9DQPFR47hmFR+MBA4cezwPFMQKMgJIdOVU1LhBoGNeRbcM7Z8UzYHaKT u6dQ8YjrblIk02PFvze4Bg/rC7z3R5G66xlh7eibYH0ma7+0cYcmMu6GXvHAllFSwDog6Caa6csQ TgX/CWknhp0LRhYecBjJnJ1EvqvoAJO6Ls3F+P5oHIZ9AYuFfhXc300e0k7EtUd+DOof7X35jDKc d5QAAAAASUVORK5CYIJ= ). To respect this condition, the cost of signaling should be lower than data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAVgAAAAhCAIAAAATVCSqAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAByZJREFUeF7tXL9eGzEMvvAsSYf+eILwBLRLJ1Y2MsLSrSNbl2QsGytTl5In aJ6AH0OTd0n9586WZVuW7y4hpcpSyMm29OmTzpJNJ/v9vpGPICAI/N8InP3f5ov1goAgoBGQRCA8 EAQEAUkEwgFBQBCQHYFwQBAQBKQ0EA4IAoKA9AiEA4KAIGAQkGahEEEQEAQkEQgHBAFBQHYEwgFB QBCQ0kA4IAgIAtIjEA4IAoKANAuFA4KAIGARkFMDYYIgIAhIIhAOCAKCwFvsCNaLSfe5WO28D3ar i8li/a/45IDa6qn/ISR4HtNeD9zdDjPGtp9RvX9AB/EsHih1bP3fpjSYL7fq/0HY/76dDoTrvQ3X 7r9uHvf7H5fHNW23WsCsTCzOl4STXP7Y7x+b6yjDTW9/ayZsl/Pj2iurQQSUTxvtBuyJm+f2W/cP dBR66h9Fw55vmib5ZZsI3PRaEHzS6+NBenQwEAkQOmPz6n4ntA0IXQVj64OUkTZO0k/qNE/6swU+ M38iRKFkpfdzhphpYrx6Wkc4iCIMTSegCz1JT6Vz8yNc2KwmlEz5VCcC+71zg5kBOsU8b72PZE0k Wln9U0CmZBqI5brZ9b9qpogSzqBk9nBfWjGnNqXzEE8R2g6BsQMwjoWs+RkrWhgLNvIDj5Ss934m p/H1KTmPcJCBMkcY+07JPg3fWWWxkprZ52Q4cFkd2mKJCcInhbZKBFHgo5hGER6Iw2APAz9LSDSd U8oNUAJdPHRTQgCgS+J3UzuS0rm3j7qcqdeItR0CI5wZvRm6xbg7gmMmgh7ez+xuRksEFJ2UulnC mDAgnrJYN4RZ7dhiOAAdY8Z1ChRsSaF91uz+vKh08XEGtuazj/Nm8/TLdvLWPx+a5vyDq+Yvv6jU +fDTtfXcUD3q5Y8dtFtd3zXLr70KXVVOdhWyriyz1bJ6CJsM0w/nzoSSziNWiJ22A2Hc/XraNDdf QsBI80e0YcBU9d6ffr6aO3INWJk71NOJIIyajH7qVmOKcbUry3n9+axGSm5fN2qzjMiFVj5rTABt XrcZlRIE15JdxIOhejmbMGwaeGS1AjUvmodPk4vvr2VQKAkDk7W2qHPvlfLaDoRRgxdm4946HnWg Iw7f+xqpPN8Gal9BJ0CYxKL00/CVU4ixGpMI/fuxWrefP72o5nyh/axODewr/t41jXUYqwyS/eg3 f/fRP7e7A42cRWT9/W5z842VBpS07hurrczm4WGjEkLfI6Td6l4t/5yzFupc45dINq/tEBgHqdR7 8Mu9O7pLneyBeTOSA7zvXyS91U8P5NKJJkyBTt3SpBg4J3cnpPCHNOZc/bUKNKvt+rNcLGOfmrIi aCPOl0vQLozLc/SN7076pqH9yc8Ki6+oqQirI4NwpttOtM31SrgZEognmwzhmUOCV4UV7QigbX8Y 6Ro5rT0oCMlgSloBEYuaSUGtS0vWej/ZVm6pQnRKMwbWOsgZhgiDinv6KXOSgQ0Dz6UOlmIkEu1j FFUJn3bHh3CSYMV4+XyPog1+nBDC0CcSgfKrtR9TgoyEOIgqde7jMrVEVluY2TqqllTKoeLzNPP4 kNcsTDCf142kc5JfnDhPiM+Xsomgj2c8+jkHMbJu+SSTnmSA4ln9SxQi1gxPEbCgmThxocj0reZX n217MF37ZspZ0CP0lYKpPbhF4fT2UakFepGlneN6Mbs7fw4roCqdSwtQzyltB8A4RKVeYwsNDjAn JVnjfdB97qUxc1DCQSnC+Nnop06OI9avNAgNg/oPYDVdQ5iJ40SgK/wGlPhmEhCZuHcJNFdDkz1C eJ6APajgivsC3LaZ6oToRojrDKwXtvCq0JnJqFaMr20ljOagJtuxrVOyLK3MCK93xydH3mCmpG4N sbyvm15cB5dNQRIFB+UIY2ehn7qVmGL6zIf6JO/VUvqzWa0bhIHXzLGBy71J74elQXpjDjcWxNYw vEcAfwu2q7kjfrvZTu0b251jtDeOSjlwfMrUuXYL58oiSlt8Q6tdhFaJ2mrS+/HQBlZpEG4Vkdej iyK+aEjzwyjA9P6h7xGQDqIIk1AM08l3vvDFOWbZxmAbTTCCQtBryE2YPknvoyvGOYt8TyhXSoZE CJgRcyS6gQjyetzkQ0kf3jaK3hj4voUVGM9RuMGIZm5bPL1gjBBMX8EvlK+sRIAu08Y3QkGXBrg+ jyTb+we/WUg4KLSkpQ66JIgI1T31YUZPwgj1kghaAFMpF4lB+sb+xZxJ+DTVLCypmniOXvNWwi8H FUmK2jbjiPHaw4aqIYfQNnphVWn0hsJ87+dMHL/1dggHHRPiY+s/0l8f6nooqnl8kXTsv6WrLi1P YoA6Qt5ePc0KZ/onoWqoBNP7qnTVjV35m9MTdGEz0o6gIleWq4yKyd6j6PhvxxNAidgHurAon9md gCHvVYWJMuwkE5QoJQgIAsdD4C+Tzh1fOYTo0AAAAABJRU5ErkJggk== . Even more important, with safety nets, debtholders may have incentives to abandon monitoring even when they anticipate increased risk taking. 192It could be argued that this argument does not apply to bank depositors, since this category of bank debtholders would be structurally unable to monitor bank risk taking. In fact, whether depositors would engage in active governance in a world without insurance is highly debated. Some commentators defend the argument that free-riding problems and the lack of sophistication of most depositors prevent them from exercising adequate monitoring. See, e.g., Dewatripont & Tirole, supra note 12, at 31–32. Others, instead, argue that without insurance, depositors would exercise governance to discipline their banks’ risk taking. See, e.g., Macey & O’Hara, supra note 93, at 98. This Article is inclined to agree with this second view. Deposit insurance currently covers up to $250,000 for each bank customer’s account that meets the requirement of the different ownership categories the FDIC’s regulation provides for. See FDIC Insurance Coverage Basics, Fed. Deposit Ins. Corp., http://www.fdic.gov/deposit/deposits/insured/basics.html (last updated Aug. 22, 2011). This potentially extends insurance coverage up to $1,250,000. It seems thus reasonable to assume that at least bank customers holding similar amounts would monitor their banks without insurance. And even assuming that small bank depositors have limited ability to discipline their banks, this Article’s theory of bank governance is still robust because interbank depositors, subordinated debtholders, and bondholders would have both the incentives and the resources to discipline banks in a world without bailouts. To see this, assume that Bank Alpha’s debtholders decide to save the cost of monitoring. In this case, the debtholders’ participation constraint becomes: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAigAAAAhCAIAAAB8/8czAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAACsZJREFUeF7tXT1aGz0QXr6zQAoeTkBOgNOkoqWDEpqvS0mXBsq4o01FEzhB fAIeith3cfS3q7/RaCTvymsy2wTbWmnmnVcz0ox2c7Tdbju+GAFGgBFgBBiBVgj812ogHocRYAQY AUaAEZAIcOBhHjACjAAjwAg0RYADT1O4eTBGgBFgBBgBDjzMAUaAEWAEGIGmCHDgaQo3D8YIMAKM ACPAgYc5wAgwAowAI9AUAQ48TeHmwRgBRoARYAQ48DAHGAFGgBFgBJoiwIGnKdw8GCPACDACjAAH HuYAI8AIMAKMQFMEOPA0hZsHYwQYAUaAETiswPN6czRcN68fynpStc+Pmw+l0xyUkbgCVNk8fh6Y 1AT2D0xd3MxM7GmmwVyIXandYQUepeT1i3ix6Xb746JS5fndJjl0f7re/r49np9wBy7RxY/t+vQ+ Cj7Ht78lidYP5y31+3jUzQcdJvY0DJsVsctVPMDAU67krO8Qa+/F28Oag85kVhJBZv3wtoA2PpON yR13TOypSXDIxA4Dj0pB7DOLVb0z37vkKZqhGm0er+5W19+grY5UaApLzBaoXeZphjbHt08P58v7 maYyD9QiTOxdGEu/F8O5NbFHc0pu4JGdXnVP+81iiR3k9qm7Kot+jSTfPN5UuC5Mo9fvd6vzh/+b ZQ0bARVPKjp09JbuKFnaHH+5PF/dfZ9dYXBvFnHRGx9zJnY0B+pAFt3g3J4rsXOBVdVLTLb7/GHd f/T/lanw5I/wLTt+C4/4cm1rPMMACeG89L1Jrju6Orj4P1rBgQLAAIL9LbpbCgl0CYkpm4K4KkXt 5XaH6OWVLGIR0lYc3b4YdDG1Ao66iBTijCmiugpQUd81YfZI1BXgedxIy440OzxiB+U4wIqNfNe+ iI156FbErnRKsO064wYS3tKheZPp6TillKMOfQckuabHQE930gc/mWkMxh7IoFpAO2YUOpJA6kq2 hyLojHT0EO3kv0IuVwpEL1MoN/2HWvpCu65/YBPRvkaqzLoiDV14I9qyAmck9ABDkQIPTeUMIpCt C6nbB51g9QMYTg02fK9N7FD8wIjde64Ut8fxXTQr74/YSOgpInZysYsSuNYpJW2nA08Czt6ipOm5 4xYnvh1wIfHsBSWPmw1oA6rA7j+Niht3/L81kKkNVBR5YFgHjYa+hIC6T0Qv/aPjg8K2EFA19m05 P12P4nsXRAok8sRzjsRsmsrFgaeUuoYB8X4wJpxQFGuW9J5VgMcecVxiG+KnuD2W76JZeZzAMxLO A+VKid2vNomLTSdAFDqltO1UjWfz6+equ/4aVRpkcnGSU8vmoQZdOu+fcAgL6Sp5+fMX+mgLKPnm z5vwwacnTgbn5PS8w/ryW+fSk3I52Xcve377o4WUJwU6pGITaLR+X3Xd2afsEWphBmUFVK/X56XX 2cVXEYiWz31NAwRqMvsSACQ2KccZoY1iwfuaOHRZMxKlvboKNOly1BUWc48/KgbBE9dtdvzpjKxM OeCi6ymJLT0Ewu3mvouMJN5wDJyHEUqJLSe+vL69n+in2coPMZGcEmI7FXgkf4tdb60BZDX1+ata oS+fH80H9WkRqC/nS8ZPgJKreZa48fj223W3ursaDgm83iyWHXysDNNw6F5KoIOHDjtP2LM4sUYx 7HISCyyOPn9/DwTA9AI8lry7D4ltTVxLDeC+CpwztBkgGU9KOqWdMYupG8grB5Xn8AlLQ+W4gfgE IVABuIw80VQdi9jwgstyu6nvGo8y1j/t6ECsSBXE7gPQS7fQASj1LHWdU8Js1/45HvnonljAK0+5 /CkO0anVvIzZ1k06Bq6As9OrfXt4Vp1Z7vuUYL+c3ZlQf7ToRBYL2da93Q+PuA9WkcKazYSc03pK y3M8pAA27I8kAsAlARJxeLVcroJgjOoV9qQQ3esFQQcLlGi5A841tKkGq5DS2DgUE+vN1YmlNC74 5vFecPQl5PjBErv3FtXm2vnGfRLbXU3urIjrE1UmV/hFOPaM5JSs7WTgUTGAkPJJ6Om+DMS+0cb+ BWuiVir4/iCPa0ryix8iF7kagstVdynrq/3GxKwUTXVLPFmYCPQqzHeX4ny5TmOLDrUuwgov12JT Iq7FUk9puXHSf9mXsezwKhYZHVU6We597EYY0wtFaxcT+/aV/k6r3l+QmknoIimxltPjTKI0TWWT OKBSuoa6Rtp+nWo4jqdJ9D587YUdJrZC8h8kdobv+JPs4zqlvmiN1ZlIJdiywwVhCRis8Ec1s6gV 8YiGVSBWRfv39ImAQS8EBVuYtGVDUDTvy4zwolNzti0pHqaXjxU6Vol9aTXYgAz0AfCWNJyTuiaM nyuxElXGKb07daEJpnpNy08rhc+a2MGxKA2CA2bOA5CpR7SybwVy78NZVdhN0ogdl+pNb5XEtifz Ce5PD1XklDDbtU+1qaCrSoLOJiudha7fidnorkY7v/wiKjFxQZ9ceU2WWJwzBTbzpvJ9YKHJ0yhb 61aPJjunBNw1i6MXLFyzwl1mc4pVp/xb0TqWPbuRxTlNmzEIBalLp3R+Jw9SF7oNzae+3pzcnb3k a0CzJrZMMIA121lwuz2xh8xNRIcCYvd7PfkePXUVHiEjOiXMdirwlB6KKJk5cNugJCj9SPwAv8xG ZOhFklxWX/rzA3EtKVGWVztxL4uUaii6B88UuOfdDAq+RnBdSwwbJ09AGFy9dJHMnmILTwKRgNrd rqYHKnR0kGVmhIhzmjaTFqJJlHYQJlnEM7FO43qcTB+MNG9KGzzK681wI9U6VMDlQtKbqqMS2/in FLdJMH4MYkc4D2qVEFsGHXm4S17kF0RWOiXMdv0GCss20TeUxHybl95K9R6mLvwttrvJRDaKUSJN f2GzE16ywsuH+GmMVEbOf77E/RTv3cn5RZX507va8PkcV28/QejKm9h7J4AqsS8pI4FCVwGyMb0V H8EZoE2aKyTNSSrnKB3nknN5MIBxwVeB9M4QEQjiN/+B0uApVPBZIIdf+yR2P/HdB0jtBM7ASLKw SSLlE+77JLZJXAGJVQACsto0jz1Qq9QpJW2Hv7lAE92/yOlARCU1DR6G18Ik3xsQggxVgnzPbwc1 skMJcNVNf7kNgv69dmAqPRrcfhHLFbtEOEHtDxuOi+jlvk0l1hsAqsK+JC8cvNcFfV9DHuQo7Hhf BGoVxZ1M5t0JWFnW5yg9EnX9F+YAKw8laMAgTfXwCUxwBvTzZ2bE9nUKuA17gFJuz53YRXEHITbI jYQ/dFx4vVOCbdcHnvh9LrRQWNUqFSuczmD/Ac3eppL76oJxw1oofkFcFA3gyKNHMYuLKoTBm9I+ ebwxJumJjjOiIrgyHm1hmKX0zKiL24kOeModMrEpM2F3nA3+0V5tNGIHaozmlIbAkw6oFASL2mQd YHL3DM7ehpIXqek2TmqEJApGs3E2nlerNa8b0aQLTLqx5meW0sDrjoblRZu3lE5jKyb2NLiGvaa5 PS2xATlyh0BpgLiBxyyzSWeLab3DrbDVUKKkYTpKBZ5WkldpjaoLvDq0apCCm1D/XNDPrJoSQE69 MnwMv58ZXkB1kNSt2BfZW/LBeGQGfUhiG+qkvH1K57FWVCObyHYXBp7JBrIdm1xUTeDEZm8Dyaca Iu+2phr5n+gX31WO8d8iECj9Qam7U2j6J9g3oZLTE3s64f8CMxJ9x+xP/nIAAAAASUVORK5CYIJ= , 193Here, the participation constraint is determined as follows. The debtholders expect to receive the value of their claims with probability data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACcAAAAQCAIAAAAavvF3AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAATJJREFUSEvFlTsSgjAQhjeeRS0cTxBOwNhY2dqFUhs7Sw8AJaWtlY1wAjkB YyG5C2YTYhZhxpGJuhXLDPvt49+F1XUNP7fRz4kIJFSZBCxI5FfSyCPGotyFVh1WVsUceFwZBy0T ACJzvocnFdIioGE6JCYAwDn3TdW1GQ5Snw4pCNmea21ailHVXOXlVMynY3/zxCHqKeoHqpXxYsXL u6Rq8oTNo/NSdao8BOy8RIEUpwuVaHGrPqaa9DtGtB+maVjdClgd6zQEmMxQJi/26b6Gaa+arxs6 IXkvxd686Y6PzyZYq222pw4bkgkmk/UW4p0qufGthOy2OsGa1bE2QMiZ4EKYGK0b0N4cImkPxwBj 96ZKFlRfCXeO2rkNyqFv+/WpI7EJdRCj+xEC3h0Y9pc/3QOyrTbuFjEY6gAAAABJRU5ErkJggk== when Bank Alpha undertakes Project I. That is, they expect to receive:data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAfEAAAAQCAIAAACJP9G5AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABzhJREFUeF7tXD1a4zwQNnuWZAseTpA9AWxDlZYulNBsR0m3DSmho6Wi2eQE mxPkodjkLvlG/xppJEuyDPliu4HEljQz78wraTTO2eFwaMZrtMBoga+zwH75Y3q/gfEXq8Pz5dfJ QY/MpHub7/7eTY5Nsl7l8dVe355dvcCYs6fjNsa3Xu0ydj5aYLRAkgWAzg9HSOjAYzfN62FohA6Q Te7+Hl6bmx/LvcLv8hkgWi2S4PzKh3rkdJjozvh1uxYarm/VfyUas+4sA5d04bZZLw1gfn/xu/bz 4PhaSa6n0LuytF01TjZgouKO1iCeh/jJgv4ZiCfjFXeMYjQ5eFfNyuHzoUQxs+rk7nX+dhMjiayg 7GY6b6ggsjD1mGv3NFMt+bpBXPpb2HQ4XzlPWR95M9PAmt7kl8ljSQlMX3K2RIMhNWIf0DyL+mSt yLtK0piyrKUrodd7spD8QSYL1rEQCNeAluW1iIWKY60R4tiaJwh6PcQZID7SGhsyUigQtX9VQZPH PRZrcFEsnNg2got6akz7prOZFUW6edSnuAB9oSaNJZNFItS/DGLhZyp27Rh2VLee0nZZLUBG2SZ5 LNyRmmBmM9fdkG19YSx3j1HtauHdTVPWFdPjeDve2mYjEa+ujtpkuUD4s6sUgI8j/i9W3PYBzOkC hFMG3dO3cBZ3ydNbDUm8TNBY4WOBGHPyNDd20MSUfvqAelEsedcK2DJO902HF20IWT86DbkRcWrN OsIXrNzL+v1l9vRLHNFcXi+al3eWMzHfTu4eFpu3P5Be2n1sLr7Dicnk+8XmYyfSKrBJCx7v7P9t Z+dTsQOANBVs5tLHgh39n7dm/lMd0LA01+HwOs/a9HR5OFnZyc95c/9b5pm6jMhTeZ6O5UAgAwIW zeJaoAwS632ZL3Ca4kGtBwB6PcSR9RFeZKSkg6g7zkcTWuioZd0MAFAREziKgeSa7T+dVC8KbN90 iFltvoWkveRRNjACIDS01YQHdCifPj0X0c68x74kh+Pu98vHrZoNqIFhNri4n4pDY+KKjwUeLmaQ WtcGRAnnu+N3mUWCyjKK7Ip+UMlyILABmaeI2ZrPlhvF702p4iGthwB6C+LqYEW4m75azlkiDq8i JQiidp/uaDKHQ3E3BEDlQgdFMRidZD1l6wSUW0wHPSlkTfzDMnn79OoXG0WR5fOwxelMdr4Mdy+N rBoY/nJakNPP+vf9xcNdI49EyXNQdmQMG4OXK3lwmD5WLSZX/fDDa3btnpr7qSsscTdP2Sj6XXWp AAQsCZ4Pu/NHTjDTjwe1KOimOK31MECPIK6NipOuWUUkdKTQIGr/6gNN6HwYgIKiWVGchLJrOkHj NN+KUgN6BRylL3mkbXE6HPIymhPLCaiX1et+b+3JsjBAz/AQcPmOp12myxuoYWVMuX0MnBPD4mKx 2s3fGJGmj5XBg2bCBHsw+aLlJ0yJ8KbK3C1T1hU7T7aA0lWAkNVpfFoDbncXjZUVHzToGb4bfJSO lBYQdW+V0WTL2CFHcTdAbdMxS4b4VqRe6UUngaz8CmaCx/Mdy9ug3IvsTJ4U8Bw22+Xpy2TY1HQB XC7SLn66jtZf71bTx0o2pJkw0Rlp1rKIGixH2VACrLNstYBg+Vl1OsHAoJcKwgzJirek/U4a9Iju CbvyBOcmIiUHRG/x3hqz7UnckwYUDNZuAQu3PJTtdB2BrNVvfNGJHQcIHV4jkExH5dPFG1QylQOn pRtx8geJZEMHoss9W50TOR/HU0FrneRQ5G9ml5ax6mapjShGHVNsTN3VurQqWz3zj8xYDAQ2INvx 6ZNcAEPkTDsoHtJ6CKC3IJ60K/dYPeDwdlSSIFZxY6ORdzY4BEAZp7nnd+5ZsQtYAsoR03EWtfjW ehRmbh2dkkDpOAVm+niQhL5f3tq1jLK8xq2KNkXbbg2etRwmSqWsuiirmNaUR4maSqdPXWgZLAa3 +/Kay8RluJbRru9UQ+ASMQVZnrJVaxnNGwFcGC0JZRyucRwIt9CYKJWlzKKSwMko45pJpISjwomA 3mMto1sT7UWKD2INN47WMg4wimvVMpKmo/mWePEgjiwmRNhkOJyOD3Pin5xKTelk6L0kXK/LS5WL Lv/th1bRSocKdNymrMNnnGbpauVI7XyRbbyhPCB8x8wYKK44ZjX8SQxyuqC72pZVLovMKfXOUWUP VpO/7ZWOqzga0VF3uoB66zJ3vSSXT4VvIXSJhYyAhd/vyno662E9f9RxTuZ/xdbMEjz7YUc0tYQ6 MmlrG9DvrzLich1zZGZUgW47Y0fEQ+T5mQ5Pekcv64//SRQLFvCWKeUzdzatlDY4g4YJ5zTjI6MF Rgv0ZQGWUDVlpX2NUtQvJHDfr4/wt8WKlMluhI4eRWswCJSXdK67yBYlo0GPv+GVIcX46GiBgVuA 1952+Y27fuwHB4DX70f3c3T96Ip7ZVXippZE0nmobPwzBEoe4z99EfrdVEK3EgAAAABJRU5ErkJg gk== . Conversely, they expect to receive the value of their claims with probability data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAcAAAAQCAIAAABV4/KnAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAHBJREFUKFO1kMsRgCAMRAO9eLGEFJR6qMO7aQZ7iZvwGUe8uqedx26AJDOj RXlFIH9RMlPBfNFuiEs1UhGthaFxAoxshDzh8kCjcD6gQ6+AAka5uSjFbSzC8ccxh579NgXK13nQ vr23MV87gzDpc5M3e7l3P3jssuIAAAAASUVORK5CYIJ= when Bank Alpha undertakes Project III, with the interest rate on debt still being data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABwAAAAQCAIAAACKrYi4AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAQBJREFUOE/VVLsVgzAMFJkFqDIBTACDQJsmG2QAXLJCBrA3YII8GrMLkfzF jqHg0USNhc86dGc9Z+u6wtVxu5qQ+GJSwdiy/59j1NURqegzF+07pkyiC6tVSS/ccdqyn+gp76pB 4pqOBCqHSlXYlQp5Bx03DKc8lfN0L3OAvLxPs6ReRd8CHxvTtiadHoU2oE45eoxi+cJen+FpKXFj qxnlgBcRu+FRykirka+VKxgD04BUOXPgr0cxswyO0tt8ylOAZtQ6xsIoD2zGTv29kQLdKHWiLzOF OmP89btjlGhSF3YqAtIf1JJuxiiYssjT3WlNAJH/pjdSmv3tg3LJo/UFZNis2oj4/ewAAAAASUVO RK5CYIJ= . Indeed, because the debtholders avoid monitoring and, therefore, have no inference on the undertaking of Project III, the interest rate remains unchanged. Hence, under Project III, the debtholders expect to receive data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAfYAAAAQCAIAAABr48rAAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAByJJREFUeF7tWz2W2jAQNjkLpODtCcgJdtOkot0OSmjSUdJtA2XoaLdKEzjB cgLeFjF32Yz+NdJIlmxDFrCLvI2R5+ebb0ayNO59fHwU3dUh0CHQIdAhcIsIfLlFpzqfOgQ6BDoE OgQYAlaJP62/9b6tTwiX/dq5wX4lb5Jw7qe93nRv/8SU8Mu6vZ/iMXmRoczOk+CNjjuY6L7jO/sv u1yEM0xN9jTRQhZKL0DSnrZ13TMTfJwvSYY4wdqmSs1cbs7D9Dw6R3ana8cja8KVpw42auAqV6Ni tCr537uJJSF6kz3FrslOSJGCrP8KcUqI+N36H1Im7yuhvlyuCz1tm61tx+q1ZRV/kF7rZ8hfq93H vrtYpJrmBoiEuqaFXoAcMnBmyEtDX1PXPTOBwNklRzodEO3JfKGi1pTMlVSxaGGyND2dPTyuLbvT A+jWWRKuiptIG4PeqnsmEnCzkPXDqpy7CSqjQhRxU1Vru2qDbL/C2gNwiRfDdxP4R/5g2Ur96ZLb hWE0GhEG2OQOTQCk19aDHiZp7nv+EtgqhMOWuxOjrMN2WNsKEJ6ErRjwXBXo1dZ1z0zw1jd1Szwi A5kvdNSak9l1wbXEyWUxJyhWV6azs/5DwsVE8cmzO6vE+6UPw2XSLR5NHxlTg4UMtlFz+vNajL/3 81b/RVG+Hx6+wlP9rw+H95Lv4Eyfit2vR1dQ//u4mL+g/Rox5PT3OBoOxN/92dvbrL//vRmtfgoJ jz8mxeY3e8zc7c8Wk8PrH76bhM2G5wGj7TjXi9rj09wP+p6j1w/Qaf1SbNFimpCXZiHD3goQ0gUB KiY/RDhgkF7P+8rSdN0zExycc+KPxqIAkfmSHjUtOC18FVRxchklbnU6x4Sz6nBb2e2XPlEP/XSr iKaPzOOvD1mDRcpCiQfOiFqtr8N84G8ckzdt8p3Wy6Mqz5jATNXxL97lF2V98QCqnjY03wdDUVOY k/YlJhTf7NpZIx6MO1jX/ZDvGcZ6nu6nz8XPmTsn17VQlm8RIKwLZm85y4pfVLmvwIrJoclwz0xA OJPhV1v0Ivn0hY5vIrRX+RKMWjzBc3PZoUo8l0F4PJ25dkOP683ulCAGSh8ZuOpohksJzNyjIdFR A7OAuMpVMR/Ik1DiJoSML7LlhLR/mT8sZoU8TvUOUOVC3zGHiYXXic2TPIYEmWqRjkfqOUgRJaNE Jg0lvdZPNnOf9j3JLGLQfrocbk2Blyc2zSxkM5x4E8MXSC2HS15sBu8LtTpopuuemRDCWaCuccWv /PB2G+IKnS901Foic9AFN5dFVc9O53aTRTp9wexODSIBFyOAn24V0QyXEb6p8jaLNU2yXZHCXX2b m+wvqM29ASvtJd+jGayfX8dwaFuujkuiFYe2Bqapya4cv7LZpD/bsnlFLGAGc5iD5D4O9RKQWiPN vArvC8ziaG8L6bVW1bb7ebaBGbA83sj1uvDm6agwEka2aiGY91xsxYQPpd5tB2pVF9/yu18mpLIZ jaPzpSJqZyMzjiDn4hnS2QEqL4Mum91VMbUJz8aSgUuNJlYGLXHLYcl2bBr1xasJC0q72KPxt/S0 Xl2sA3Ve7eWIvSV1CMyPCNirir74u4es+1UIulM4O/0xx62RxVGa4GT3IwabOT/RNoOP8ibiR7KF 4DBlJNvqVac07CWaXpIJtJJ13TMTAjhLvqW942NyEvmSEzUtLDl8cRf4IsPal81P52vP7uwgGrjI wNWJJtR3WJnJwgAl3tkfBRPlLgtbMMoMJ28qepzY2t3aOvAKZGhjzUg1h7fyYTByoIXCwetBnNda JrWwyW0ZSjlomnUbuN/CpmKKpw0sZLDq4xisi71o64NymFwLvl/WQNc9MwHhTC4iUt7xA2Sw84WM WitkjlAlkss8b6vSmQMS4mHakis86pLZnRJEO4es0kcGriKahNNQj98Xsr6f1lPVNGlWt3afhl7y kjflattaflKNhLgXCrf/WU2zrgFOc6M2INiDb8tCTaLWxibZ0ymbQg1WSoXpVqrvfmtNk15HpbRJ NmHWt5DohKNbbMkPJ9we1DgZwk2Tt8+ENpsmERlE6L2PURSfLYKollef6ipHsnKZfzOh9ZIRlI2A Xj5S6ew3TVpOXUN2ZzVNBuCy8ti0V/s33UZKHVHY6DQfsvC7I17ixadPtT8Zslu9ceFR+y3yoyqP 5UI574uvdeWaHS7xtdQLAkfcd/vZY63QcdtyPTX+xC2kQnIuXd707n0jcLtMIHCOkSFOx/oBistt gSr1I+h9FZldlP53dteoIQ3gStYmS7yotM63o8lCggN9kXqOqVvVPV1nMLu54z6caiYOfvpUrfQM ngZFtq3rnplwLWSorP/403I1vA2qXIyH1VmWNqINp9M0NR7VAwlNd7q65zsEOgQ6BDoEPiUCjTpq PqVHnVEdAh0CHQIdAhKBf2w7LN/m/PwlAAAAAElFTkSuQmCC . where data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAoAAAAhCAIAAABvO60fAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAK1JREFUOE/tkr0RwjAMhRXPQig4JvAK9IzgllW0AktkBCbIUWB2EfpDMZyT CaJKz59sPek8EBGsR9pgjHbc3c++lv634b82FUVl4vwrXAFmzaSkoAurkWOQG0SVAUDG2khRvvP6 fDC83w5/Dgy/XzPk6yWgVMP5yDqeNmca0dp6i4y+P1Kw+fLbKqJWMF/OiDb8UqdtGOvIS+NwIEky 16exv9MEOsRq+MIb4+3rH0jWxa3lC7i4AAAAAElFTkSuQmCC is the probability that Bank Alpha will undertake Project III. The solution of the participation constraint is given by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADgAAAAhCAIAAAADPf8aAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAbBJREFUWEftljlSwzAUhiWfhVAwOYF9gkBDlSM4JWk4BY1dho6Wisq+QU7A UGDfxUhPC5K1jkYpPCNVifWWz/9bxnhZFrSFU20BkjIW0NyVKooWRXMrkDte6dGiaG4FcscrPVoU za1A7nilRy2Kzn2DxTmNDslVI2mNmx6RL/xsZ+pqVHeTNR69E5fwG7WDzXBo9QuwJaZZQElwOC5I AkRNlGvwsJPq9IITQHke5ieSRkRhwvgBeVoDLJL0//0QSUaZ6JO2438YrRNVvItPQYsumt4Qw1MB 8FfbhZeeiSMdVYtVI61qGNffZjxPBhlSlp0+4etp+rkSzI+Xu+D6O1yWYX/ewUA2/Ry0TzcY385X 1D4fWAQGOv9+o/r4JDEpN9rfO7AJK6vM8TMZ2J+BMo1f70S7V86JoPSaxmKgIqZJFCk89dZh8rWo 0RoAatkdoT537kq743pzhobevKegWpSYLo+bIN1KHfNVDpPKMrF8j9Zdx5d2aA/L3eSYksDS517m qlI7zbZZMCn8CT+iYbnItk0f1Bt6VmziH3Y3zJEldIVgUWzg8J5LmvKUoUr1+QOQnZGyPu3pBwAA AABJRU5ErkJggk== . This means that, as long as the debtholders expect that the proportion of banks that will switch to Project III is not higher than data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACMAAAAhCAIAAADcc4UFAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAWJJREFUSEvtVrtxwzAMBTOL4yLnCeQR0qd1J5fxEB5AatNlCXsDT+BzYXEX heAXAJG4yJ2KhGxEEiIe8PBAyczzDIuMp0VQEKQh/Ybqxl5jjzPQFNEU8T8UYcetqcd2tCV9+sr+ zGgpJmEAOO+NKZvum3vqoT+5ZxrT0AHd8etumNDu58TozsYVzuJLwVEx+SUQhDiVQMIFLjMU9cY9 oxcWf40kY2OeU6zJiTPmPNB3WtB5TEDeRnY8fkD39rpKtbD3q2Pl5Vk07fWeqni5TcE23S6wWeNB O+4OMHy+ZyfeztmTzMXCMP6rsgWSeMUYcUqdKqYeIUWEkJREDOrBgZGynCr5JLFVmuLFFrrVcuwG gkRZIWdVRTBo3h/RVKmyICnMeRdaB32TElUiRfJKzEgaczFYHwPtXD0j3k8SqU9IPwDlHirVrdtd 3gi1FpU7QnHzcEsN1HORVWnwRlpk/MU/li+y44vdw8pa3AAAAABJRU5ErkJggk== , monitoring is not efficient for them. And if debtholders are fully insured in the case of a bank failure—like depositors are—then they will never have an incentive to engage in monitoring. 194With insurance, the pooling interest rate is determined on the reduced support, which is data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADEAAAAQCAIAAAAwDgDYAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAWJJREFUSEvNlsF1gzAMhqGz5PWUCZwJuHUKc+ypG3QAc6Qj5F4zQTNBXg6x d6GSsA024Cjkgi8RwXz6jX4pKfu+L3a23namB+WgJtucSlp1t6qwq7O3GScLhOUA858a6zXBp1AG ithWGbZQX7nbDFWBkAZVC8m19Ahm7ez9enw/MPKubgmEeZA+w9RkbseP195SIMyDx5qw3OQsCqjE tvn+ud6p1pyVIwRUjgmVNEoMfqJQarwWoqBAavqevzYTwE9ORRFrotzotqe1RKq3EEZNC34CE449 1tWuQTlF83teJMw12d/zZeyxqv37fNhvYKDpaNtAiE4812RuF+l6DIcpJqOhWjc0Wik5uTjMOHgt EfN5QlKEBT+N1tCSfGWMVgId6E2vpW8Kst/kIm0GFsG7OPb4IDQ1tlHS9aPL6zIM5/BtkutJHsGP 8ImmVSjtRaEOjUJAiXK/Aoze3EQod/hf5R8EcOGL8rRq1AAAAABJRU5ErkJggk== . Therefore, Bank Alpha’s shareholders solve the following maximization problem: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAPYAAAAQCAIAAACqbRUAAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABbtJREFUaEPVWr1y4jAQ1uVZIAXDEzhPENJQpc3MFaaE5rqU6dKYEs9ckTYV zZknCE/AUMS8C7erP0uyZEmWfcmpSIzYXe1Kq91v15DrmKPKs6LGBao8r9SFqoLNswHfwgCCusiz TKeMUE+uxnnqIiNxwoCDKxyxbDwpKkbygv79jX9xUTqpPcQL/iYcxsbjx3+xrQ7rb8iI4/J5Om6m P2AsTrMpW+iwop83dP5ue4Gpy+dsucT/21cymxNBGanYYfUye1tPIrk08suf9+P8NkmEc/nL9g4N ZxY/PBdZ+U7ertfdz9t5VqDek/XH9fqhPqSY8qW8k4fHrNwfvlSHZvFRXbw+z2nshmssPed+R+M2 i+J4ooTUhEyns9Piifx6IKdePgYXZ79k0hJGfT5mPS+YZ9XL9un8jOmK0k0mBHaGq3u/S9bbtjhe KXaf4gaGoFWqd05u5+T0Gb94jKoOA9v6j+jil+1LSe08vG6ObuUPq8XmXGMM+1jXnZROGSCiJOVC xMgOOgykYrQc4LAvieWCDXDokB5ochLufPnkuUqcE81td9stTXHcw1i+C3E4niEkKX5+ghzR5+5g CFru3beDreW7BNNZdjxD6Eof0jaZAmm+dxpo0f+bwLcx1GhjcWVGQl+1JDAgI6UhWeaD9BCcuzG/ m6CpHzDCgxQoR3iZ4pUqKxnKKDmHKCi6ZMB3/goHlJfwuz8WZ0ULq+KaZQMMVElGjOLpN3gMCQKJ TNZvhR5poHIwgjiFx9e3x1Q9ULJ9wDc8b8BTXu3uMd7zagDiUVc4FQIh92TFr3uAP+sdIjWU8PiQ CNkATZPNqx2v1Oewcik5jAO625Ci3oFtiO7WH+wpxEBV/xuReJRyiGdIJZHLbIFz4gM+M9I+mC/V bfrwt8vJsQEj0xIwvltdAFiQ9kG1+RJOEEjZBN1ZwF8SOdEJBAgc1NBCHRI20NCanmMHw0YbV0uX BgxIAIIVo7Y5Ejat9qXQqUM4IJU+J6TyIL7Nn1v1laUn0K3/DVwOSCol1HpQ39cFgd3aL2kj7/j+ hxYMIIB+KeYwtmEewlABlkAe6YP5UjegDz/4T45+1AwVenc6Yp/lAnhYnoDoJGIUq8Zhgj3QR3YG +yVk39PLHRyPLN/Z4TFEwIOduqiDS9cLiKbvjygB5as1YhOGwZcXJ4aflqRkexgkPGALXCSY+ozT spL69aeeK6Fk82gDPOocx6lqe9vA0wnmEUUU70KY0pRGq/GV5DWxuIoP6YHq0JuD4VZV4Gqv+xUT olySIwsQm5iWcq0Jz+LNpuiEqhxl4wy3cApX2dtYPGDrnADeMNCvfxAWF4lg2uqMdOGtyAPUyBWv FeHMEKdkjsCrBWGBZh422mkwNrc2immFYXBKk2k+MBag/hR0KwOzdneos3EpArCLJN5dkEpPBaJs QbTPN87AwR7hTsP8Z0pZA/rHAfr7XbzBKaKtq2CXiiz+FyCOMFcBkYsSq7tA70ons/TbKcgLV8H6 XqrdyTdAtJULLpfS9RP5sCIvTR/dwQdBDvbwsGLsHa/KklEfttbl6yNV4VaV4NVf+C3tV7ESQX+U 0/BFjq8usInGqASvfO3M3kB/l2EmS8VRrV0vHcjwRpWPidUo3U1D+/fm7w0822YTYsUJWia3cWkE 4tBlc46qoeMRgSvyilGL3euwe4imoQpnVL+K1F9FvQmuybu5kaeWsGAIqwtEu3h7Q2aPi9v7uL57 EWChy8Buw/2HFNB49mjX8sJhQ5/nZHX9h3FxlImx3f9KIODgBiOJdXHaJxo0C7FfnwmfoiHQ/PVV grWd9uF97WNMXz7dDm0nnZVjgu0MQVgMbE8P4+ISpfs3VWafAa+DQ2a0i0czBMQyRHb82tR11XRx /LG0Wzi1ecA9THI3k1nfyHFcPFjhgVw8eL2mjzb88Zi/2I332PQM7fPL4a2O3vrxGYyN/2IX/wvq eh2G3963oAAAAABJRU5ErkJggk== , whose solution data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAYAAAAQCAIAAAC6IZmZAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAG9JREFUKFNj/P//PwMqYELjA7l4hbanMzIyWk+8w8AANAsItqUxpG2D0oyY xkNV3Z5gBbUnbRvI+DsTrVVXhd0GqgfKXLkFVAU0x2oCSADEAhrJAKZhAGwF2F1QRf+3MbRAHIFs NEg7FkeQ6ke4tQB7+U5hIczAugAAAABJRU5ErkJggk== is given by the first order condition: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAI0AAAAQCAIAAACkxGtvAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA1xJREFUWEfVWT1y4jAUlvcsJgXDCZQTkDSp0tKZMmm2S5kDmBJmdme2paKJ fYLkBAwF5i6s9PT0a1mSMU4GFcaW35/ez6cnQ86poypo2cSIm5ISUpRw/cOvnAcmrZuYGP0eeAml tKj4ZFWwJyGMP4hJUylM4BC8SCy4BcMNDpJocyBKpjuapmLOwYAmRTaoX0rQkpqyUNmi4mQqNaIE lKYRNxynX5CfkVEvs93T50vuIzutFoc3leh5Tg6zCknn6w6emD75/nTcz+6YVvnL7j62hM/AmEzJ 8cR+LaWK92O73y4y0/DTkUwnqbq/je60us/uV3wd1mA+z5a1norXE2KNCSAWtlhwqPKdVxl/A9y0 LAGwEHakxCgKtQidEsUCMYsMYJALlrzKvO5qEogQtSbuKpMCYcbAaTDN8ZYCH2RFd4kNhj1I8lTc 67KRiepYn3Yp182ItDe7mSKuaCOpsRTJ64sHd1ooDhjbfpEIUIstU2yGhmzbfjdqPC7Ao/2jSAbG qXv92jq8s13h8W/MSRdHNyYYPJPQJCXIESQSS1wGO4NaYfLJlw4eGCcsFY8GhSUyPgKHWL74UA/m FFpd02ch5ypLCo0KAUvUBmDvJC1ru53i4qJT4hoq9QuM5mhxSk4+BAZuD+XgdG0ICiC2bkwRo0D3 UEtiGIsGuWS6CK1CQzIWp0iaOH2Ivey01EmJmU/SGD2X3sXUHu0A0MA1dYGe6wQnTnojsPUjGevL 52uvH2VP7bxM8R3vKa2mMs7EWm9a/p7bhCnx7UuDGurdhj4/QofPe328hUefJcAFy2oPT1MNp4le g9lDvl4nXPoDqc5r0xOUnSaSzk9BjVyKMyZTBh+WqpjNzFdf/RcXk5ryvl5OXrnqeilOKwFLIgmN 2vK7Gdns8OTDQmsegkyD8sdnuofzHw65z1XkXR+nlDl987GFe552t3/3NGYv51+h7mZUxwOE17DE 3EkCPZGFfL4ewjhwDesj/K3lNZY6LH1uhTvSchjuvRT3BEw0B4Hs/NtHtlzB9e/qfUOsgk6Bn4to LtgHL9IzGlP+8nl+2mVd340W5J/68hZPPVXFBsJhlcqivvLn17hN4jRZssP7d7XxaTaNRpWOe+GP zT/wKVrkivrLw0md0Tz2M4L/A7OWO4elnXr1AAAAAElFTkSuQmCC . It is simple to verify that since data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAG0AAAAQCAIAAACTJmYeAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAaVJREFUWEftVjFywyAQhLxFTpHxC+QXuMsP0uHSVf6BS5f+BP5IxoXRX8gd ElgKQkjicBNfYd+M0O7tcqDjxhj2imwH3rIRXgDoQNTH64HzwxVWhAmVcx6ZCjDEKa3C40/0Yy2/ 97ayMKES7pGpAEOc0io6/JiPzf1n+15BWWFCpdkjUwGGOKVVPCTEfNS37aftxjChku2R1wA2px3f nZrEq6VV9CQYowRUI1SX1FIbo2UNp3k0ge/78piiWIhmofCuger6UVpFQgKTtVBgGwR4CQkaShsW NJui889ueBA0FHHZaXyGL2ON6/xz6v6cr6BbMihm11daxSQ++oi94o+JEqEJ+f2ZT9HtWHy7BxT5 FY/1/IQz4CNehuu6cXa1dBTR401HMa4qgQ8+QmnORrcY/5mQ+Ns+i93uM52kp8CCBu3Ro5hZ1LJl CXx7Pz5CCWub1qr9YrsPD+FpfwLFModIVg/nx+bOPjbQg1XFbkxejpUbkPbnC/uaMbClR8EnUKSL KLBifAjTUrjxEdpStjMbyS3q57ByFCQNthCEw/oCu/PvIH8B1B8+E5zsjY0AAAAASUVORK5CYIJ= , then data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACIAAAAQCAIAAAD8lzozAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAANpJREFUOE+9VMsRwiAQXazFpIikgtw8WUJytAkLCEdb8OQJKrCJkF5wF9DB DJAMGt4lDIH3YReY1hr2x2F/CVIoLiMHxljL57/Gk9wRYm0QoodeeF87+yOQlNCMSrOMFph5W93P 6nk5ppNLKWGaoK6rDqxjNTZuiwkVgWcvtCJBQjL0m5KZkR18w9Hbc40gTYIySOK4iW5JFZoLKKVJ NJDKBxG7bkkizBqJuTfvgxJwDTZ0dzP+Tw9secQgQ6VPk2wtv3dQZH1ZwpUeymnojAtc/LHJ8Lh9 S6E0L7KlEwguWzDQAAAAAElFTkSuQmCC . In particular, in the case of full insurance, since data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAEkAAAAQCAIAAADVkMW0AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAZNJREFUSEvdVztygzAQFTkLTpHhBPgE7nIDd6K0G3cpcwBRxpPGbao0gRv4 BB4KpLsQ7VoSHwFD8IaCLexlWN7u03tIQ1BVFVtpPK2UF9Aa5JYnQZDkusJPqJbDIVMBdnBGdIvF aYfVfkI1jEMmAVTpNsDYpmpMN1XeoudQV/gJyRxNZBrAPNkco0xvH1Kw4x7YDekmi+gVVfMTmlEa yCSA+ffZuCA8vPHr148CbmB7fLUwQT1V+n6+lb3JrEHGWkwAxMf9MNZDAG2vFtC1kIyJmGdSxDoY JhxkJQ0E/d8WYESY38xtLhhcZpzVN/7EC57siVjIDsz8FtPmATqua4MbrKkbJuP+YNPgx6oeazFl BXWNG9zkWreWnI/T6ENYoEVtPieh5qZZWqfaGeCfcQG/93tm5eZKukCLekj3fuH7VkfGkYqU2d2/ dnMhdOoCLQyf9vmmSvay0VqFISuYuBxCe7rtPi5sb8/7Cbv2cMkCLVzzjmzGhFJw2F3Qm7EQZjek OB/Q3QDUbvFJ2MJSClb8jfMLDpmNSWT1qP4AAAAASUVORK5CYIJ= , the shareholders have no incentive to signal.

2. Inactive Bank Shareholders

The distortions introduced by safety nets lead to a theory of rational shareholder passivity. As shown by the simple examples above, 195 See supra Part II.D.1. with bank debtholders’ opportunistic abandonment of monitoring, bank shareholders have no incentives to police governance arrangements that induce risk taking. Instead, these arrangements serve their interests. The fact that shareholders suffered large losses during the crisis does not contradict this thesis. This is merely the ex post story. Decisions were made ex ante. And ex ante there was weak, if any, debtholder discipline. Bad outcomes were only remote risks. Hence, managers pursuing more risk taking were acting in the interests of their shareholders, who had no incentives to actively counter risky management actions.

Consistent with this theoretical explanation, empirical studies observe that the banks that suffered the largest losses during 2007–2008 were also the ones that enjoyed the highest equity returns in the prior years. 196 See, e.g., Andrea Beltratti & René M. Stulz, Why Did Some Banks Perform Better During the Credit Crisis? A Cross-Country Study of the Impact of Governance and Regulation 2 (European Corporate Governance Inst., Finance Working Paper No. 254/2009, 2009), available at http://ssrn.com/abstract_id=1433502 (“[T]he banks in the worst quartile of performance during the crisis [2007–2008] had an average return of -87.44% . . . but an average return of 33.07% in 2006.”). Significantly, these studies also find that while banks that made aggressive use of equity-based compensation were among the worst performers during the crisis, they also outperformed the market before the crisis. 197 See Ing-Haw Cheng, Harrison Hong & Jose A. Scheinkman, Yesterday’s Heroes: Compensation and Creative Risk-Taking 4 (Nat’l Bureau of Econ. Research, Working Paper No. 16176, 2010), available at http://www.nber.org/papers/w16176 (suggesting that the banks tarred today because of the aggressive use of equity compensation were “yesterday’s heroes”). This same story explains why shareholders tolerated lax risk management in the run-up to the crisis. Under the modern model of liquidity production, a single asset can be more or less risky depending on how it is managed. In other terms, risk management basically serves to control tail risk. 198 See Gilles Bénéplanc & Jean-Charles Rochet, Risk Management in Turbulent Times 7 (2011) (describing risk management functions as decisions on: (i) “[h]ow much risk to take”; (ii) “[h]ow much of this risk to retain and how much to insure or transfer to financial or insurance markets”; (iii) how much capital to keep as a buffer against the potential losses arising from retained risk; and (iv) “[h]ow much liquid reserves to maintain”). Apart from the first decision, which relates to the acquisition of an asset, the other risk management decisions are designed to modify the risk the asset’s holder bears. To this extent, asset risk depends on the risk management policy of the asset’s holder. But because shareholders profited from tail risk, they had no incentives to encourage stringent risk management. 199Consistently, empirical findings show that before the crisis banks with stronger risk control invested less in securitization operations, despite the higher profits. Andrew Ellul & Vijay Yerramilli, Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies, 68 J. Fin. (forthcoming 2013) (manuscript at 4), available at http://ssrn.com/abstract=1550361. Finally, the theory of rationally passive bank shareholders also connects to the abundant empirical evidence about captured or ineffective bank boards. 200See supra notes 95, 108. “Truly independent” directors put their reputations at stake. Because independent directors will suffer blows to their reputations in the event of a bank failure, they are unlikely to share the preferences of shareholders who are seeking tail risk. Therefore, it was in the interest of bank shareholders not to counter widespread dual-hatting practices 201Several policy reports have attributed the lack of true directors’ independence to the widespread practice of vesting CEOs with the position of board chairman. See, e.g., Basel Principles for Governance, supra note 20, at 18–20 (highlighting the importance of measures designed to constrain the potential negative influence of dual-hatting practices). or demand more independent boards. 202This argument is also supported by empirical evidence finding that shareholders at financial institutions with more independent directors suffered larger losses because independent board members encouraged their banks to raise more equity capital. See David H. Erkens et al., Corporate Governance in the 2007–2008 Financial Crisis: Evidence from Financial Institutions Worldwide, 18 J. Corp. Fin. 389, 390 (2012) (investigating a sample of banks in thirty countries from January 2007 to September 2008). Indeed, while the actions of independent directors promoted banking stability, they transferred wealth from the shareholders to the debtholders. Id. This is consistent with the idea that opportunistic shareholders will tend to dislike truly independent directors.

III. Reforming Banks’ Regulatory Discipline

The previous Part discussed banks’ governance mechanisms in theory and in practice, explaining that an apparently weak governance of risk is rational for bank shareholders unconstrained by debt discipline. Part III puts forward a normative case for a reform of bank regulation aimed at incentivizing more socially desirable bank governance structures.

The corporate governance deficiencies exposed by the financial crisis have induced Congress to include in the Dodd-Frank Wall Street Reform and Consumer Protection Act a number of governance-related provisions, including new provisions on executive compensation and shareholders’ access to proxy materials. 203 See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 951–57, 124 Stat. 1376, 1899–1907 (2010) (codified in scattered sections of 12 U.S.C. and 15 U.S.C.). The governance provisions introduced by the Dodd-Frank Act affect all public companies in the United States, not just banks and other financial companies. Among others, these provisions include non-binding shareholder votes (i.e., say-on-pay), measures on the independence of compensation committees, compensation limits, and clawback provisions. Id. In addition, Subtitle G of Title IX of the Dodd-Frank Act, which is titled “Strengthening Corporate Governance,” includes a limited number of provisions about shareholders’ access to proxy materials and disclosure obligations for companies that combine the CEO and board chairman position. See id. §§ 971, 972, 124 Stat. at 1915. In the banking sector, however, the new legislation is unlikely to improve corporate governance practices in the long run. Subscribing to the view that weak governance arrangements in banks have been the result of managerial opportunism, the measures introduced by the Dodd-Frank Act aim at empowering shareholder voice. 204 See Sepe, supra note 36, at 229–31 (discussing features of shareholders’ empowerment introduced by Dodd-Frank). This reform approach, however, disregards the fact that the absence of debt discipline in the banking sector makes shareholders opportunistic principals who favor increased risk taking. 205 See id. at 225–27 (arguing that Dodd-Frank’s failure to consider simultaneity issues in executive compensation design has the potential to exacerbate, rather than improve, compensation practices).

This Part suggests that a better approach to improve bank governance would restore effective disciplining incentives for bank shareholders. Empowering private monitoring of banking organizations through the elimination of safety nets could appear as the natural solution to achieve this goal. But safety nets are an inevitable response to bank runs and the macroeconomic shocks from individual bank failures. Therefore, they cannot be eliminated. Accordingly, the necessary premise for effective private ordering of the banking sector is lacking. In response, this Part focuses on reform of the prudential regulation of banks—or “safety-and-soundness” regulation as this body of rules is more commonly referred to in the United States. This regulation currently focuses on banks’ capitalization, based on the belief that larger equity cushions provide sufficient deterrence against the undertaking of inefficient risks in the banking sector. 206 See infra text accompanying notes 231–32. But concentrating on capital requirements alone is not only socially expensive, it is also an imperfect method to constrain incentives for increased risk taking. Instead, ongoing legislative efforts to strengthen prudential regulation would benefit from the endorsement of a contractarian approach: bank regulators should act as substitutes for bank debtholders, exerting the same kind of discipline debtholders would bargain for if they were not implicitly or explicitly insured. Consistent with this contractarian ideal, regulators should expand the set of regulatory tools they use to discipline banks, making capital requirements and deposit insurance premiums sensitive to the risk propensity of a bank’s organizational structure. This would incentivize bank shareholders to depart from current CEO-centric models and to seek, instead, the implementation of safe governance arrangements. As this Article’s analysis suggests, shareholders should be driven to accept advocacy models.

A. Self-Regulation and Safety Nets

In the absence of safety nets, governance theory predicts that bank shareholders would actively seek safe governance arrangements. Accordingly, the elimination of safety nets would be a path to supposedly beneficial self-regulation of the banking sector. Advocates for self-regulation point out that this reform would expose bank investors to a real threat of failure and therefore give them the right incentives to monitor and discipline banks’ risk taking. 207For a recent scholarly treatment of financial self-regulation, see Saule T. Omarova, Wall Street as Community of Fate: Toward Financial Industry Self-Regulation, 159 U. Pa. L. Rev. 411, 413 (2011), which suggested that a policy of selective intervention designed to exclude systemic institutions’ access to safety nets would be beneficial to promote effective industry self-regulation. Self-regulation advocates also suggest that empowering private monitoring of banks would mitigate the informational asymmetry problems that affect regulatory action. Therefore, it would also reduce regulatory arbitrage, which occurs when regulated subjects employ “a perfectly legal planning technique . . . . [that] exploits the gap between the economic substance of a transaction and its legal or regulatory treatment.” Victor Fleischer, Regulatory Arbitrage, 89 Tex. L. Rev. 227, 229 (2010). However, two reasons suggest that this is neither a desirable nor credible direction for policy reform. The first is that safety nets successfully protect the banking system in uncertain times, avoiding catastrophic spillover effects. 208Since the crisis began, 490 banks have failed, as compared to the 26 bank failures that were registered between 2000 and 2007. See Failed Bank List, Fed. Deposit Ins. Corp., http://www.fdic.gov/bank/individual/failed/banklist.html (last updated Oct. 11, 2012). While these figures are significant, they are not even comparable to those experienced during the 1933 banking crisis, before the adoption of deposit insurance. Indeed, about 9,000 banks failed between 1930 and 1933. See The First Fifty Years, Fed. Deposit Ins. Corp., http://www.fdic.gov/bank/analytical/firstfifty/chapter3.html (last updated July 24, 2006). The second, which follows as a corollary of the first, is that legislative commitments against the future use of safety nets are not credible.

Safety nets are needed to avoid individual bank failures that may result in macroeconomic shocks. Even a single run may have systemic effects, either through contagion effects (i.e., “bank panics”) or interbank correlation. 209 See supra Part I.B. And, as discussed earlier, in modern banking the risk of runs has drastically increased because of banks’ growing recourse to short-term liabilities. 210 See supra text accompanying notes 183–85. Therefore, the protection of safety nets is needed even more today to protect the integrity of the banking system.

Given the essential functions served by safety nets, no legislation can be trusted to end use of these measures. 211 See Narayana Kocherlakota, Taxing Risk and the Optimal Regulation of Financial Institutions 2 (May 2010) (unpublished manuscript), available at http://www.minneapolisfed.org/pubs/eppapers/10-3/eppaper10-3_taxrisk.pdf (“[N]o matter how well-written or how well-intentioned the legislation may be . . . . no legislation can completely eliminate bailouts.”). Despite promises for the future made by the current administration 212Before the enactment of the Dodd-Frank Act, President Barack Obama expressly stated that this was a central intention of his administration. See David M. Herszenhorn & Sheryl Gay Stolberg, White House and Democrats Join to Press Case on Financial Controls, N.Y. Times, Apr. 15, 2010, at B1 (“‘I am absolutely confident that the bill that emerges is going to be a bill that prevents bailouts. That’s the goal,’ Mr. Obama said . . . .”). and the explicit anti-bailout declaration included in the preamble of the Dodd-Frank Act, 213The preamble of the Dodd-Frank Act lists the need “to end ‘too big to fail’, [and] to protect the American taxpayer by ending bailouts” among its core purposes. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010). these commitments are simply not credible. In the jargon of economists, anti-bailout commitments are affected by a time-inconsistency problem. 214This type of time inconsistency was first informally discussed by Kydland and Prescott in the context of government investment in flood control. See Finn E. Kydland & Edward C. Prescott, Rules Rather Than Discretion: The Inconsistency of Optimal Plans, 85 J. Pol. Econ. 473, 473 (1977). Recent economic research has looked at the time-inconsistency problem affecting the regulatory enforcement of anti-bailout policies. See, e.g., Viral V. Acharya & Tanju Yorulmazer, Too Many to Fail—An Analysis of Time-Inconsistency in Bank Closure Policies, 16 J. Fin. Intermediation 1, 1 (2007); V.V. Chari & Patrick J. Kehoe, Bailouts, Time Inconsistency and Optimal Regulation (Nov. 2009) (unpublished manuscript), available at http://www.econ.yale.edu/seminars/macro/mac10/chari-100216.pdf; see also Macey & Holdcroft, supra note 2, at 1403–08 (suggesting the adoption of a “Bright-Line Limit” to avoid banks becoming too big as a solution to the limited commitment problem underlying anti-bailout policies). Before a crisis—or in its immediate aftermath—policymakers understand that expectations of future government support will engender moral hazard and other inefficiencies. 215 See Macey & Holdcroft, supra note 2, at 1370. Ex post, however, the need to avoid systemic collapse will induce policymakers to renege on prior promises, especially in the case of large (i.e., too big to fail) financial institutions. 216The failure of regulatory initiatives aimed at limiting the use of safety nets is often attributed to political self-interest and regulatory capture. See Frederic S. Mishkin, How Big a Problem is Too Big to Fail? A Review of Gary Stern and Ron Feldman’s Too Big to Fail: The Hazards of Bank Bailouts, 44 J. Econ. Literature 988, 992–94 (2006). But there is a more radical explanation for the ineffectiveness of these initiatives: safety nets, despite their flaws, are ex post efficient to prevent bank failures from damaging the economy as a whole. See Adam J. Levitin, In Defense of Bailouts, 99 Geo. L.J. 435, 439, 451–53 (2011) (suggesting that for too-big-to-fail financial institutions—defined as those financial institutions whose “failure might trigger socially unacceptable macroeconomic consequences”—bailouts are inevitable). In this respect, while the Dodd-Frank Act subjects the ability of both the Federal Reserve and the FDIC to rescue troubled financial organizations to stricter tests, see Dodd-Frank Wall Street Reform and Consumer Protection Act §§ 1101, 1104–05, the risk is that regulatory discretion might be reintroduced upon a future financial crisis. Therefore, policy reform efforts should take the safety-net system for granted and focus on prudential regulation, that is, the body of rules that is designed to keep banks safe and sound.

B. A Contractarian Approach to Prudential Regulation

Prudential regulation comprises the system of key requirements and restrictions that regulators employ to maintain the solvency of financial institutions. At the heart of this system there are four key sets of provisions: (i) supervision rules; (ii) activities restrictions; (iii) deposit insurance rules; and (iv) capital adequacy requirements. 217For a general discussion of the basic principles of the prudential regulation of banks in the United States, see Richard Scott Carnell, Jonathan R. Macey & Geoffrey P. Miller, The Law of Banking and Financial Institutions (2009), and Lissa L. Broome & Jerry W. Markham, Regulation of Bank Financial Service Activities (2d ed. 2001). The need to protect small bank depositors—perceived as unable to adequately protect their interests because of insufficient sophistication and coordination problems—has provided the traditional rationale for subjecting banks to such an extensive body of rules. 218 See supra note 183 and accompanying text. However, the steady increase of deposit insurance coverage and the evolution of modern banking have paved the way for the emergence of a more fundamental rationale for prudential regulation: preventing systemic risk and, with it, costly ex post interventions by the government in support of failing banks. 219 See Acharya, supra note 70, at 225 (“It is thus broadly understood that the goal of prudential regulation should be to ensure the financial stability of the system as a whole, i.e., of an institution not only individually but also as a part of the overall financial system.”).

From a contractarian perspective, 220Contractarianism, as a general approach to institutions, assumes that legal norms “find legitimacy, when they do, in their ability to secure (under the appropriate conditions) the agreement of those to whom they apply.” Geoffrey Sayre-McCord, Contractarianism, in The Blackwell Guide to Ethical Theory 247, 247 (Hugh LaFollette ed., 2000) (providing an excellent discussion of contractarianism in contemporary moral and political thought). Modern contractarianism finds its roots in the monumental contribution of John Rawls, A Theory of Justice (1971). these rationales can be unified under a common substitution hypothesis. 221For a discussion of the differences between this Article’s substitution hypothesis and the representation hypothesis articulated by economists Mathias Dewatripont and Jean Tirole, see supra note 12. According to this hypothesis, prudential regulators should act as substitutes for opportunistic bank debtholders, exerting on banks the same kind of discipline debtholders would bargain for if they were uninsured. The benefits of this substitution are easily grasped. The public provision of governance functions addresses the vacuum left in banks’ governance mechanisms by insured debtholders’ relinquishment of power. The realism of such an approach to banks’ regulatory discipline is confirmed by the close resemblance that key prudential rules bear to the exercise of debtholder governance in private contracting. 222 See Dewatripont & Tirole, supra note 12, at 87. Like monitoring and informational covenants, banks’ supervisory systems provide for close scrutiny of banking activities. Banks are required to disclose a massive amount of information to regulators and are subject to periodic evaluations, which produce examination ratings. 223 See infra notes 254–55 and accompanying text (discussing examination ratings). Along the same line, restrictions on bank activities—similar to investment restrictions included in debt agreements—constrain banks’ abilities to take actions that may jeopardize their solvency. These restrictions include operating non-financial lines of business, concentrating risk exposures to one borrower, or having excessive interbank credit exposures. Further, provisions on risk-based pricing of deposit insurance premiums approximate interest-rate negotiations. As riskier debtors are required to pay higher interest rates, banks that pose a higher risk of causing a loss to the insurance fund are required to pay higher insurance premiums. 224 See infra note 257 and accompanying text (discussing the mechanics of deposit insurance premiums). Finally, minimum capital requirements that mandate banks to maintain a minimum ratio of capital to risk-weighted assets in addition to liquidity ratios can be likened to financial covenants included in debt agreements. 225U.S. bank capital regulation is largely based on the guidelines issued by the Basel Committee in 1988 (known as Basel I). See Basel Comm. on Banking Supervision, International Convergence of Capital Measures and Capital Standards (1988), available at http://www.bis.org/publ/bcbs04a.pdf. As embraced by U.S. regulation, these guidelines provide for a risk-weighting system of capital ratios, based on the assignment of assets to risk buckets, each associated with a different risk weight. Under this system, a bank is deemed adequately capitalized if its ratio of capital to risk-weighted assets exceeds an 8% threshold—with eligible capital being defined on a consolidated basis as primarily consisting of common equity; preferred stock and other hybrid instruments; subordinated debt; and disclosed and undisclosed bank reserves. See 12 C.F.R. § 225 (2012). In 2004, the Basel Committee enacted a new set of rules (known as Basel II), introducing an additional methodology for risk computation in large banks (i.e., the “advanced approach”). Under this novel approach, banks can opt for an alternative system based on internal risk management models and rating agencies’ credit assessments. See Basel Principles for Governance, supra note 20. In the United States, the advanced approach was introduced in November 2007, with applicability limited to large banks. See Bd. of Governors of the Fed. Reserve, Interagency Statement—U.S. Implementation of Basel II Advanced Approaches Framework (2008), available at http://www.federalreserve.gov/boarddocs/srletters/2008/SR0804a1.pdf. In the wake of the crisis, Basel II has undergone intense criticism for giving too much leeway to banks in effectively setting their own capital requirements. See, e.g., Kimberly D. Krawiec, The Return of the Rogue, 51 Ariz. L. Rev. 127, 144–49 (2009).

But the substitution hypothesis offers more than just a better descriptive account of the need for prudential regulation; it provides a normative framework to define the scope and shape of this regulation. The contractarian argument underpinning this hypothesis calls for a reform intervention that is “normatively constructivist,” under which “deliberative rationality” provides the justification for banks’ regulatory discipline. 226 See David Gauthier, Political Contractarianism, 5 J. Pol. Phil. 132, 133 (1997) (“The contractarian position is . . . constructivist. That is, the entire normative structure of a society is conceived by the contractarian to depend on the deliberative normativity of its individual members. Each from her own deliberative stance must judge the social norms . . . as ones to which it would make sense for her to agree . . . .”). This means that reform intervention should lead to a regulatory framework that replicates the hypothetical outcome in which bank shareholders would self-interestedly agree to negotiate with uninsured bank debtholders. Governance theory predicts that this outcome would involve bank shareholders’ commitment to more conservative risk choices through the use of safe governance arrangements. But, in contrast with the contractarian ideal, the current regulatory practice largely fails to consider bank governance and focuses instead on capital-related rules—primarily, capital requirements. However, as explained below, this is a crude response to address banks’ risk taking and the negative consequences this conduct may have at both the individual bank level and economy-wide level.

1. The Limits of Capital Requirements

The argument for the overwhelming role of capital standards in banks’ regulatory discipline is straightforward: reckless risk taking is unprofitable for shareholders of adequately capitalized banks. 227The standard reference is Daesik Kim & Anthony M. Santomero, Risk in Banking and Capital Regulation, 43 J. Fin. 1219 (1988). For a more recent contribution, see Anat R. Admati et al., Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive 16 (Rock Ctr. for Corp. Governance at Stanford Univ., Working Paper No. 86, 2011), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1669704. A larger equity buffer reduces the expected gains from taking more risk, functioning as a sort of deductible to be paid out of the pockets of shareholders before the trigger of deposit insurance or other safety-net measures. Based on the same argument, recent proposals to improve the effectiveness of prudential regulation have suggested that reform interventions should be directed to raise capital requirements. 228 See, e.g., Viral V. Acharya et al., Capital, Contingent Capital, and Liquidity Requirements, in Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance 143–81 (Viral V. Acharya et al. eds., 2011) (suggesting raising banks’ capital ratios and liquidity ratios); Admati et al., supra note 231, at 2 (arguing that “better capitalized banks are less inclined to make excessively risky investments that benefit shareholders and managers at the expense of debt holders or the government”). But concentrating prudential regulation on capital requirements is an imperfect and limited approach. To understand why, consider again the example on excessive risk taking, in which Bank Alpha may substitute Project III for Project I after the issuance of debt. This time, however, assume, for simplicity, that Bank Alpha’s capital structure only includes equity and fully insured deposits. Under this assumption the interest portion on debt will always be zero. 229Full insurance implies that all of Bank Alpha’s depositors will be fully reimbursed with probability 1 in the event of bank failure. See supra note 187. Accordingly, since data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAB8AAAAQCAIAAABhmjO7AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAL9JREFUOE9j/P//PwPNABPNTAYZPMRM357OyJi+HRoiVHT7nYnWjIyMLVes EIFNRdNV8o8Ck8jCMKSYBJoO8gsasJ54B0kNFgUg9aiKsKeObWlp2/7fnmAFJP+DaKsJt4EM8gHQ CAawWSDA5Dlzpuedrat0AjwZGIA0Q5i3CvUSKTjcb19j0FIF08d01DANpyBkgO7flgbxC4QGBxX5 ACVkGEBmQgMKJAFjk2M8RD8MgNzIOFrO4EhmVMyrWGwAAHgrEX44t0y2AAAAAElFTkSuQmCC , data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAEIAAAAQCAIAAAAtcD5DAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAUBJREFUSEvtVjGygjAQXTwLWjicIP8Edt7ALpTa2P3yHyC2HsHKRrgBJ3Ao DHfB3f2ZKAaUkR1ndNxqCezb9/I2QFTXNbx/jN5fAinolJGnUZTmYiIJ7mdTAYSJSA8cqtbItDK2 6+YT6x4vTJ5As0b9q3cku9yoTsdkEotslDxIno5XSYbqrYHVgjzukmHLZD6TJyCCmO+3yqyJXbz8 1cXuUJEMmlY+BpzwAFebv+3xhEkz+IEwuOQqWgABW3O/liSsvd8CB6VRUpQWwCid4aRhACeazBoQ DCEJGHChc+FZugugpzINlxsDJPhSccBrUsTcv36cDDob6JKbtQej23Oo+gOG/Xq0iCfJpc6WhZqO Ad1omCThhTjgLSlvtjcGZeDi0APR7CMOGO4tCeFwzKPvP5XIR0AG5NN/DWV26VUoZ89y5WpXS3Lp AAAAAElFTkSuQmCC always holds and therefore the outstanding debt is always data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAkAAAAQCAIAAABLKsIUAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAI5JREFUKFNj/P//PwMOwIRLAiiOT44BaOb//9vSkLVbTbgNFoXI/b89wYoh bRucyQCWRphppaUK1qySv3CC1bFrt2H23dm66piOmgqSwVdu3YG65fa1Y2kBnsh2glSCzdy+YRbM RCAPZAiEC3EIzGlQN0OcBZID+gDqRohnYBwGkOuRAEwcpI+RBuGJL6wBm8JvTpOqPlsAAAAASUVO RK5CYIJ= . Hence, Bank Alpha’s capital structure becomes data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACAAAAAhCAIAAAA3RD4GAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAWVJREFUSEvtVjuSwjAMdfYshoLhBOEEgWarPQKUHIQGStxxAypygs0JmBQk dzGSP8GWNZPJLpnZnYmbOLakJ+lJSjKttRhzfYxpHG1PAL0ZnlI0pag3A70CUxX9rRS1p1W2K3t9 GiYwOskCPji4btvIse3NnXeP5piL/NjQY63xwq9UTSOAEQFlfIKIeQ1FO/AUwKsirkWiGADQGXQA Jhwvh8ZxH1p6RYG3AarxhCCwHBRnfS5s2LDt9gm75VUJsZxLf1F8AoK6RnUCAHLzlQu1zlaHeliB tI87BLCYEa37ow1OMAK5/8asVEpVAPSbQp0tXoQ7EJ8iTIVlCWJ5ZzcQDlwt/TSOpq4iUtjfFrm/ QCSEKpYcOV8KUdVNfElIgQjKHZOSlDsGw6Q8cIVWlVFxTexqHYuaFLeter4P7ABwncCLmFFB5kTU sOEkYCdCoMyNEj+LnJfstEnnz4CT0adp9u9/35/llN+8xpEiIgAAAABJRU5ErkJggk== equity and debt. Note that this change does not affect the preferences of Bank Alpha’s shareholders for Project III, since this project remains the most profitable for them: i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAbQAAAAhCAIAAAA+islVAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAACHlJREFUeF7tXD16Gj0QXr6z4BR+fAJ8AjuNK7fuoDTN17l0l8YuTec2VZrA CcIJeFwE7kL0t9qRNJJGiwBjhiaG1c87r16NNCNtBtvttuEPM8AMMAPMgMvAf0wIM8AMMAPMQMgA O0dWBTPADDADCAPsHFkWzAAzwAywc2QNMAPMADNAY4B3jjSeuBQzwAycGQPsHM9swNlcZoAZoDHA zpHGE5diBpiBM2OAneOZDTibywwwAzQG2DnSeOJSzAAzcGYMsHM8swFnc5kBZoDGADtHGk9cihlg Bs6MAXaOZzbgbC4zwAzQGGDnSOOJSzEDzMCZMcDO8cwGnM1lBpgBGgPaOS4mg/Zz/bqh1dxHqc3r 9WAwWXRNyx/g9310Wq/NmmjlkGBjoSgynz0wU9OEesRSWmINU1jKlqkpAFTDJyTgbuc4elmL/9tx ++dxiBG4eZ0kvGb6aXZAVAFJ2kPzvt2+3dAqfO1SN2/b7Xvz4K4VwuTh4x85TOuX0YnbX0MzPgVp De+fMNawwzGq4VMSsJxp2/m4aYyw1Hds7oHnyMyEtbvH47luzn5kR8GPpj8HgAEFuA6ryX78Sgh4 vyJEj2HxIBO/SssiaB26cDPamsHTpI310FsVJAk3ugg4zxhIUBSR5FSxQMO+jIuYP7aGHTl5hO9H wOkZV13DqsHDCTjOJ77NUJQ3CecYhZ40rPN/gVxjrlE5Z6c31YMAKP8VD4IOra3+RNWmdm3pgt33 tuHOiVYYoARaD4+CA3vM48HdY21t5QiHDg5ZRq1JgYGtPyMDFi1gK17Wffpq24X542pYcWg58BSc F0yWKbTAoTVM1gPRnAT+JJ/S94SuR/9S3TlCP+f6POPoQmNDnuwvtg4woW0VysSZgu7ccqarN4Oi U5k4IrpYAm3YgYuAggf1jpW1lSTckKF4H3sxRs5AS2QJYLP0lS1bWSrpzB9Xw3K6hoGYISNrZZFy u8IH13CJHgg2pQSc4jNoGuLax2n16PJCR2cXl6Nm9Vcf8GxeH6bNy/9IPnHz++eyGd+lM40ifdHm ImUmozAv2SJa/Jo1zdU3m1W9uRNzffYLnADVyUu1aDd/V2IP0NJhOVn+/K1JIeEZfr8f2Rp18BFa AYRrqJPb1cv67c6tmjOQ0BFSRI6wWHMun+XBU78TwhywHPPH1LAwH2b+h9+uLEc52P34RmuduoY7 ASf4DCxf/JguR62b2odzXH6sdafrj6VxRdo1vqOHPbKU60Aa6Q+a2e3g+sdH2XAPH5/GzXL6YA+P xJyeNeMn3TEyY+TPrf8u66orHUerdG3pCNon4pGtxBvpi9qplyNcuUZk+DIG7oTNZO6fPi56+Mhd mT+ihn3SlEPUmweiYHrQfuoazgkYUAL49InavD7PmtH9d7N7SjnH1bO9NYIs35Gncrdo9mIShR5U 6Y9bD0UaOTkxxG54OZsthZMsubIidx3zq6maUOJz24jsQXyfKdHu/omj1VvTZ+ur5SKxTHQYx0P2 4OBKi73zA//Ad2JJwmOuURhSZmBaUTgvehvZDilZCmXAdJTTfo6tYUiEmq/jeUzCdQQsOvw8Gt6D gAGhKT51DGt2UqJOxDkqR9zci4s1Oqe2nF6ASZV6Kkiej8WmTzqmmR5UuXvTf3V3nLrW1GoIQl1r iJwVOqsum6POCtmFDADbdOBK1C2KzPqNTRNBe/Om2TPu6aG5l9l2zNzdfbRuQTuT+CdyV8vUDAkX hCK7RvGrHhGqgWlFZY03kfbL6pY6mFRgSNfH1nAHSUdc68IsEry3XLBAfhIN1xawu9Qk+JRbODe/ p2aRf9LnTy3s7MNL5kZPGLtzmMgZYKpzUdmcWYfn/rQDGXhoGdaocyIDjoOiaE0ZBwIVD8JQ5Xw2 PDdxTTCHI4gLwc9L0lJxz2cKTqVbGPFDmiINU5kHo6Z7PoCGE2dYhbAJBxnYgcRBNHwwASOHTjgv oYBoOcd0Bif1FJzDdFG2CsYKsmjDx3exg6QcnMj8pbsvg+lsHKiX78xuYnIFUmjVxt0mNUrwkDeb PXe+jlXABG8dBwpCtzOugXGq6MlKbU8bDJTuoSyC/szDs8RDaNhAXkwupldzNyVUIpicTJPPj6nh ygJu7cT49MPtLt2onuDOUeBzohc3EZx+6pAudqroOQw8x5Z/e55S9BCG0RQnplIwTnrOga4eAyfr H/71ExQdrd64d0kNGh5pAsX4HcJquglpinwDbekCzbR1TA7m+TL15hZ1xPoxr1o/tIZlnzqX0YXT i4mejzTBUEkB5egC6MdkgYZ7hdUZ/DE+O316M1M/QMNqFcTYoAdGpm1oEX8K9qzwvhiMSHQu0UZI 4Q7bRrs6rMbDfjSA01i7eM21RINoHxMjwGxwQkJr0qd+WEjAc4h7jjQTYm/ItPld9/69CUL1OKcV 5VFc454jaNLXr35EYN6No/1ve9OwkoqTcgA39Yiws6LFKJcjlZpxNTVcOaxOCjjFZyeGMMkTuQSu pWM/6Tf7Iqkj1zUG+RroJoKiXv/ZdxudS+4O9hAceFyQ9EqqzUvM4a97xTrL4EF9Y/jOUOls8Mun TQD+RInCtUV7H+TFFpjSTSuqgwMcQZFNWM4xCsy3J/ZSzlE07A2FnoWA8T0IuF0solN+NyYRDVd2 jmaxQ/Hn+IyeucScY5EuscKYVoHL83ZQuAew69jOaA7TgFl1a3aWIKb6q6kS9x5MqElHoi1UcLv1 zRrejT9T+xChjwVaU8C0A5keSQyZOQhujXTpBC+xLi5PrO9/wutCPbr8clVEpkQm5eOXb76cxZ/L INbw7uNx0hru8i/B9r3KslHUSPW9dlHvn6pwbCNk4hs1WGUvH38q8+qD2U+wWY6TNWw5QzV8QgIe CEt2Xx64BWaAGWAGvhgD/wBUtlXob6/38gAAAABJRU5ErkJggk== .

Suppose now that bank regulators anticipate that projects like Project III may become available to banks, including Bank Alpha. Therefore, they require Bank Alpha to raise additional equity capital equal to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAB8AAAAhCAIAAACuvOezAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAWVJREFUSEvtlrFtwzAQRU+ZRXEReAJmAiONq4xAl84A3iCN0noEV24sbeAl rF2UO5o88o5kAAcQggBiI5AiH+/+fVJqpmmC2drTbGQCL/SavIsyizKPHr3FM3/vmfHrtdkNj1bu p/nzVhXw60GttyIG2/txftw6A2C6mx7P1zLIdEQPC+mJWNfVeDdYwzNBxmJ7VGa8nK5gD/vWb9ru DzIRHB8+P8BaA9fTZawJvV4FAkC7WoPdbjB2jtXHXs4dRamLQ7rmYuIXOyiDWVNwpTm8aw1PcC4J dhiSVzXjJymV8b4mrFgkBDrJEWelOwi9nLWUc4QLsJO8VvSgbkxOSerwMj2hiyxaTk/KfPeyDDXD Fw3sN0FHDrvC+Tcvz6TjcD6a97foNIDNFqM/nvnCuPsZzRdbAvTHlJL1msVMKaz8eMrotS4iFaeM ugYCUHshvyvUwjCBIyrpXjhOvxya945s/vEf9jcoPOrYPDMlDQAAAABJRU5ErkJggk== to deter the undertaking of Project III. Further suppose that Bank Alpha’s manager, as occurs in reality, will invest into one of the available projects (i.e., either Project I or Project III). This implies that the shareholders’ expected payoff from Project I and Project III become respectively: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAN8AAAAhCAIAAADWA+kSAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABeVJREFUeF7tWjtyIjEQFT4LbLDlE+ATYCcbkZJBCImzDTfbxA5N5tTRJjYn 8JzA5WDhLmy3vq3vaJgBa6s0iYHR573uJ6m75dHxeGT1qRYo0gJXRaKqoKoF0AJVnVUH5VqgqrNc 31RkVZ1VA+VaoKqzXN9UZFWdVQPlWqCqs1zfVGRVnVUD5VqgqrNc31RkVZ1VA+VaoKqzXN9UZFWd VQPlWqCqs1zfVGRVnVUD5Vrg8urcrUbquXk82JY5PN6MRqud+RF/oN/LNSQiOwtatJdnqJLsMCRr LgD5gN8vr0407PRhD/9Xenxfj20hLtjz8fg0K8n2X45l9nQ8PrOFvWq/HNWZAIzX7yiM/cNUTIBf 6Hf8bfkmf9V/dHP/rXnldXtbBsbCH6U6zSw4iPsjNiRPGJQ3kkumExeXdofvWWh94nwGp68mTcmF LER8F7QDgW9N0dY4n3aCNZVMN0VJdYLnUJ1iHO1GPiN1Kn8vGTltuWFFW091QW0G2sm+lozUlPgX XvCvtIG2im/oFFrJNcIl5BQJIO2vNrRkxUSEQUGb3cJeWckVnBIcN5ZuIEznL9p8SdINDYYN+KiP orSxhDo9NTpCc2RnNacKtNUYdau/d3raM2rUo0AvZVA1j+dRvQ8RVznkUlyC7slRp8YfQitHhYmn y6VZ5c5kvgkIYdXWkWfaDva+6e7CA8gzwbqPoqy1ecUOfz9gZX2fkEN08n3KmpdXkbLs/mwZu/6m I8TZD1h82z86ddFdsdfHX9Hp8LjYsIf7rAjy8PrSsOWPdFuIvlQ8ioFYNDZNo23jMlQ0RdCKIWHi 6fz+fk7sas21/3RN4A3B2PhuPtVuYSxpBzo6NKQR/vjb9VA87XEU5L6KMqNeMQ62+dxHEAemwpZK hqQrWlioWGjzmeY8CXtgP3t1cD+w7e3o5vdnN0Om0bZy6TaZat2K9vD4a7v8uR7zhkRfejpcNdoE kKRHyhToqrincsHzJdq2G7QPFmfdV1FUnUxshr90dQe11STQ4R6pHvws91EkLTjvfm8adEY7w2gL zN3gfGi22wZU2qemRNH606Xf5hJoQYuHg7BMRJ581TSbiSil3G6T0jH7Qi48qx2uFAiSBiiMxFn3 UZQFFitKsyeIIbRxRgs2x8CZHOZxMwDCtyVscsKonPNupT6Z4lWqXsddE5oMTy4RXuMEfRTayY2k HgusJrBQBb9okVaMHkdrxAny5AeVCpokLhHayDoJMHYOkk7oWxqLU23va9NmTfmKzxEPRlj3UJSn TjCaKDOJ5/2OeZEo7YMnMZETAhQPcuaHmFTpZHMts/lms3AL73pE7rDEhiCzwlN3UAet473AW8NH ZY92fmsVaT0x+Gj5SaKjar6tOKezFdqAK9IznC5W2C3QJcHhbdZ+gtiVdR9FWSe7S5cv5en8TpzM 4SAisrxJMmQOeh469AqXxutn2ENJJhaPCIJBtELbicvJKrDRYj5E00M3qYQFHTs8wgiyzrRA192K 7xYDHOlBXCkfnawo/64I1zojYSMPzYgy3LyXYIWuwWSIZvM+NV4hsLOyYGKQdeCl0Xbg0kGcKbQ8 WZcLXYYATs0jULKI5UWo4ywreOBh27z9ICf6btX7cjTfRz0UZW3ibq1dvKTV3HCRUTczhyCtflpF w5x6py6YYRQGt55+H5gxAiWNNpOLtkpOvTOONlRAdwvMLje/9Bmpd9Kf3Usou+LowcDqq7hMPv3J 8pF70yOna/OCsoFzkxnDrO9mAreQRsJWgGbkaZfpQ0qzW+gVYbYAC5dYQ/bjTS1fBwi1cyEuy1Gn dxWpJg0B1bA5YoKF8onez+bawVJncJLe6oyyltaT5E9SlKvO09eQ3jc9HMYq7iVk1j27TEoGMGNP ctnd5U6f3b5Lw/A23GWEc7U9A2ulzoH+RwlTPi+ts7P5ZCAHKd5+/jLpHQx1iBb/p6apbPt/4tEZ 67lWVHTc1MEaj7kuDrOYCYMxdzHoBgZCYyE4cEcwfGdF1w7VAhexwD9bZPSZOPAvaQAAAABJRU5E rkJggk== and data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAN8AAAAhCAIAAADWA+kSAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABetJREFUeF7tWj16GjEQFTkLpMjnE6xPYNKkoqXDJTTuUrpLY0rTuXWVJnCC 7An4XATuQjQarXb0N6tlMZ/iaJuY1d+bN0/SzGxGp9NJlKcwkCUDn7JEVUAVBoCBos6ig3wZKOrM 1zcFWVFn0UC+DBR15uubgqyos2ggXwaKOvP1TUFW1Fk0kC8DRZ35+qYgK+osGsiXgaLOfH1TkBV1 Fg3ky0BRZ76+KciKOosG8mXg+urc3Y+a53Z9tJk5rm9Ho/td+xJe0N/5EgnI3gUt8OURlRMPl7Ra CUA/0u9hdR7X965wCB98awpx1dNB/r/S0+/l2BbiXLycTs93KVP8N33unk+nFzG3d+1HtX68/A3C ODxVaKH1ozVa66e7tZ1JLLbQnTzbhQi/JLNjd4DjvoTR5PFmDw4yszUjw8PirY4JyT+T0Ho24vTO WGM0ZSTEkAbHNBn4xt84uc9KsqGehyM+slbs6QU1Vo5p1RkF3HQN4m8FCH9ZAgtqE10REqK1vlpT 9oJ/ZYMHwfjT0zn21a+RIToz3+qbqAHwvutCS/a4j7fdT64YHQ2xOzgyL9msLQtI3mCBMlY7vKsF +3jhQuqkCrTVGHWrr05f/uaNmUWOasxr1qFCa9XjTO8Qw7cGNJiiThatnlMuXC0W7b5xlvIpIAY3 fR158jy0CwR48uRyxsnJWO1Pb/Pe6YVm7uFZUfVlgmf75Esl9n8wzzmu5yvx9JAUQR5/vdZi8Y3v K6OvJh6FQCwam+5+boS4+Wzi2btvct9ufupEi2+9XDBH0OKkcuFq9vAwq0T9+stJBaH98OZS4E0h xPjrrCLDWR66bTF+6+6a2KOBfPyzl7dXIwujDQM93QvD1Vm/HRA9MIy6QG2+0JyHMRDGOVSBH8Rm Orr98ZbIjO4WIAZa9KbhW/utRHp3oj2uHzeL78ux6hiSJ/jLUCCT9EiZYvz5Rhi6k+GOl98Xol7N TZ67u59uBOBJniLUMW41wGRw9vBCq879o0nmAwWMSCucl/pkAobxBNz9WNUDjYfcTZ7/9WZTS5UO qSkBwvjDt6Z6rwMtXA7ITESeyl/1aoKllOmGvUia6ykVnOwHp+z2ppl/NBUyfR1eGYlbjRfWo9kO cFrV53hBqVORJmaymoPpsySKCJRrlQi3C3nIIalbMBl2Jv7VFq+4ep1yDbmLjRXAKYbXsMAQhfZw JOA3FTf5x0TSivZFi7Q4exxtK07JtDpWnMsdQxtd8JAWX/zOBUdM91jFA0730iDHJbbV1F78O+LB iNV3z6giPc9czCAvCjm5wzWRTCBS+0D1+km3VblAomPZfDC3j6Wc4CvM3P0kMwTEf0cjdL41mBmk ZEXUeB+tU7oIJCShKkY4TQn25B0ScliYzzMyo+Y4i/pIz2lBTPAClxXxcQPXSpKh9qIXcND3D5do YLd8kfo0uQ2z38LgmsOIb+11wnIYLLSQD9H00E7TYJro5RFeo/cJBHG9fW4pHi78jBkfqcuhmn3F QLeHF+Bml6e6dXDbYSvfatkoA85gMkSzeZ8UaHXEG0wMki48FUgSHdv5Id96rr84tCpZ127RIYBV RZDi9EsWsbwIHJPEgmWJMtqKViN5ST/7030EeQjNwnp4Qd/B7U3uHvvqKjI3L3Mp2FcY/WVdjyn1 TnP94c0erODHQgyKN3KJ0Fo9V8bWcUxX3TqO1qlQtrVPEqe4fPilz0i9k752AzErfkCftYbaHj33 Qk/ykU4cXAZ5H+lgpPlW5HxK4z8pRtzphFdu3Gl/qej8VuR+3LMGINv2Y9mvjMcngJZvDZTJu9Tp fYpsFg0BNcjUrAQLtSfIsSd1hgcvurUW6tiRqXp1wDuzanSxtVgvNDtUfckc/gTD9RYA9W80sg/Z oc/O4QCvMsN7og0fw1cxq2ORd7Cay4r6xR+qN1QWrP9x1LxEyzqLa7IydZi90jrWGSA+7hBZEpqs brYewx/XYm3Z1Xcfd6THY66rw8xmwfR6UzaQzwdCgxV54Y7kTB9+BxYD/1EG/gKcj3ZCA9dmIwAA AABJRU5ErkJggk== . Note that data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABsAAAAhCAIAAACnV0fJAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAP9JREFUSEvtVrEVgyAUlMySdJlAJzCVG6STMjbZIANAGbtsYCUTZIN0sguB jxpAIwla8hvf0/vHcRwCEkIkm9ZuUzZFFhm3sTT6GH0MdyCmJ9w7s9P2kdMMZZQvUjOMPjUHlv9w qLbseVLSDe8mTwCNAN1StjYMNKphm0KIjqTemafkcdlrVH5V+LphdpM5ADAuaXRFg0pH5Ko8sqaW hEVuaVzByOmtlgLvNmH4ycXpuUpI5/KFnoUyZYfq2D6HNfqeR+9KA4BhRSem8uDr3z5KeaeXMVuG nZR7GWGL4CFy2r0xkVKvWu6ZPM5Fu4+ZFblxY5kcToBRvEn9Fh4P6g3d2eQcvluR/AAAAABJRU5E rkJggk== (i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABwAAAAhCAIAAABFi1ywAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAVZJREFUSEvtVTFywjAQlPIWmSLDC8QLDA0VT7DKfIBHmBI6Wlc0WC+IX8C4 QPqLcifLlqxkMmEsCjK+SqzP67vdQ0eNMSR1vKUmRL6ZNL2qL6ipFEImEwKG39TFQMdLhci0AE2l WJMaiIvaqJJUVx0ULAWlcQeIufCP9GHlsNVBEyDiWJ4lDQJgRz7Coam+GezPnTG5S8MTJ777iFSh Dj77uyD2fasW0vdvI4ojlR/t26c1xdJdMMZ+901fK1KeP1wWf8+6dLZYDv99OBe12lXZH2dAiqzd f/aU0edHw882O367h0b9WCyactmaYx48bVrV/dL3G1QKZg7VqbZZLsK2AYh5bY2O0Q13vi3I6WLH HERp0Cjvs5d7jEJyaHn4md4fP+qAoPs24pGaMv50XifJLqenEs1GpZd3uFD+444aryMn3qQdFSwY v05i8NEdFa8jeyXG4BdLdli47EJibwAAAABJRU5ErkJggk== ) and data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABcAAAAhCAIAAAC9a6dHAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAO5JREFUSEvtVcERgyAQhNSiPhwr0Aq0EPJNKfi0EdJBKmDyEHshdwdGiY4O 4y/DfRy9Y73bXYBba9nluF1GQICEsk9j4iXxErPB/t0vU9/wpp8OKcGaVdyfWA1nHYUSfm0tzfxt 8zSyhiqhwkVCEQoiYIqKDlB28vRzQRq1g7VDGyNtUFuX34mwp7Ne/NxLt64TZSP9gl2r6pF7ejsG PMAUkSgoUKdn/o3UHSdR1zqcTbTNe9GiejHvF2NVkS3cZkUVfR/lJThBjytXTqMGb5xrNMtAk7sB fjSCV8eLy4bhHRqgBCbHcg/I022/u9s+XUFQzmE1ZYAAAAAASUVORK5CYIJ= (i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABwAAAAhCAIAAABFi1ywAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAVdJREFUSEvtVbF1gzAQlTKLcOHnCeQJII0rjyDKLJAhcGlGoHJjmCBMwKOw 2EW+k4SQ9OKXAhVJHleJz/G5u//hqFKKpI631ITIt5Gmn+ofnGlXll2yQYD5VSscHa8kIusCZtqV BWmBWLRKVqS5T17BXUlp3AFiNo6XOXm6HD0MiDiWp0m9ANiSBzjCczfYoDkjatL0fbJ0H5HKMNu+ D4lc4nzhg8iKlsqv+g11QZd2CGPsO92yPSfDwzTd3WoiTrk+831m0tnu4L59OItWnpvsBw+wjy/M 0vMrhkpeDWcYgfnZ+5nPZbywF6iUjZ9mFprdFtGP0jwxPQaoFNJcdXLsDzu/bQACdnzEBXaqIz8J Ut+0zad706NQi86eBgGKM5v962cvqGd1kBHV1xFbao396bZOXrjnl8GbUOkFcT+U/7ijwnVkh7dq R8XryPy8Eu4otwTjHfUEo1FgaaU4pGkAAAAASUVORK5CYIJ= ) are the gross returns in the event of success of each project. Thus, in order to redress the shareholders’ incentives for the undertaking of Project I—and therefore their incentives for exercising adequate monitoring on the manager—the regulators will need to set to satisfy the following condition:data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAdoAAAAhCAIAAADxpP2WAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAACKJJREFUeF7tXDtWIzsQbb+1mAk4rMCsAEgmckpmh5CQEZKRQIgzUqJJBq8A r8CHYOy9+Kkktbr0q1b/sBrKyRi3PlW3rq7UJWkmh8Oh4A8jwAgwAozAsRH479gGcP+MACPACDAC gADLMfOAEWAEGIEsEGA5ziIMbAQjwAgwAizHzAFGgBFgBLJAgOU4izCwEYwAI8AIsBwzBxgBRoAR yAIBluMswsBGMAKMACPAcswcYAQYAUYgCwRYjrMIAxvBCDACjADLMXOAEWAEGIEsEGA5ziIMbAQj wAgwAizHzAFGgBFgBLJAgOU4izCwEYwAI8AIsBwzBxgBRoARyAKB48rxejkpP+fPexuQ/fP5ZLJc Vz/CD/jvLPCLGjGItYCXB1ROOPTptSSA/own7k40mOHN6PnDGX5cOYZQzZ524v9cPnzcTG3lvS5e D4eXi2bR/OalL14Oh9fi2p6mvqvP05sPIMbuaTawh/vnpbsWQD3ST1NMY4anoKTK/HSGA+OdjzUA Fu/UY+dpVdOr9r4oiuCPmqxVL9CI+yPURp+wUV5L7miOWhswLYBL8k9J1no+quadusZp7FwIIW0c 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data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAVUAAAAQCAIAAAApjHsSAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABXxJREFUeF7tWzua2jAQFjmLdws+TkBOADRUtNuZEpp0W25HAyV0tKlogk8Q TsBHEbgLmZFkWy+jkewlZoMqr5FG8/hnNJrxdq7XK4NxWX1/Y9vfs0Q8L9iEsdGa/3nHoXJxx22/ 9FbtsOwdVPwET4SSv4k12WLOJiPp7cns93oUQav+kmT23psvsvqEnhRyDbTEsncwyBM8EUoW/p/t Nun75x/22bTTmaJ32w8564NxutnpAQDieocPvjQf+Pb76hIhcq0lBee1qJAX43Y4oiVtj2XJMrsm EpADy57gcejOAyHI/6/7lPWXZ3wS47zsc0Lay/Ln6Kd9KinaD9re6V7dArgxGEH+tFcgANMXhfGI BM31SFMbxY6muuRM8Xuuu1B29O1M6WIt0SbLBpikUEYuNwU5UvmPCR6VawGhcJPHQIg5teY1FWwV CnDuGmKR/aBsaLm7+UL7W+qqb/uvQtLHrVCcKZAWFM7LVImQBkt6PHIFE69CReCQLHChSvubTmwQ uyFdJCsEbvUpNMsSyZbBvGCfTP8hwZOmqXLCxXq/7shUCGH+fz4d+t2XWvkZafH51BsPcKb9oK8/ nM7VBC+/fpalCga1ChB8C9XK+JHtjsv9sm/eOzAGF2pJZmoxNBlNmFKnQAUW1RNUZyrkDB35dsls u+zfVAKRcuss6+f7svrYpPt1rj+hEjJyYO7jgYd1u6VessVpAglvCSe/ytQZoRAC/7/8ObLea5OV fvXKAc/i3o6GPf6BC7v9oImYvPYYn+ce4P6HhrndsffZYDQxAkC5UTbVKg/IFwSAfsGkrkC4ccdE 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It is easy to see that the appropriate capital requirement to deter the undertaking of Project III is data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAF8AAAAhCAIAAAAwBuATAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAwJJREFUaEPtWDF66jAMNu8soQMfJwgnoF069Qhh5C1sHdm6wFi2rp26FE5Q TsDHUHKXPNlxbFmyneC+rwv2Qokl5ddv6ZfpqGkakVeAgT+ZmQgDmZ1YeWR2Mjup8pFrJ9dOrp1U BnLtpDKXdSfXTq6dVAZy7aQyl3Un187/qJ16OxstDqmRfsPvtxHeXGfV28W2HnyS8N8vufaV41Ht 9XPzcdmUQpSbC33OfU0gv7UnwKBHEYTOlvtWBdtdBBa2oGkLQNYlLj9hX32ldjpGIGFGnTeGPoUE 0iIIFTMmZMsTAh8E0p4IBt6m6CQO7JgAmh1VSIQdeFJWVbB6OAYewhSIPmlensESiiGUyFBF0xTj 7EgoyFshw7i8ujN/bV7nuBwPH7vyabV6KsXx/dPTtZfzUVSP2IWFsOFgS57aZD2CNbtCBBAiGx7+ +loWZqu4mw4WFQFpCTG9M97zR6Bn92EHE7BTPEDWu/vR7OXsD1xv17vqeVkoQx898i3lZNx6HxaD Bl+x/JIkPZ/H/ST1IrS4VcLuQQXZqr9PUDodbmN2+rbnz1SZVbxpOLdNbR9Q5buiZ8jbY55WesNW vI9aYSmNNLMudFSQ6qdU5W7ZLPH7ETl6tPlEv/MA6wTVtRIZd/YjxPiZv3TpHrbuxoSP4R52wJPo mjwyRBYTrpaxZEbc+0Rf1bXce4YLmi3R64GTPmeHZsdVuVi+AcWdNkk93qys3jLhEqp7kbQNF0Wt 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The latter condition requires that data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAHgAAAAQCAIAAABSoSyyAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAtlJREFUWEftVz16ozAQFXsWnILPJyAnSNxQuXUHpd2kS5nODZRx5zaVm4UT hBPwURjuQmb0AxLCSGLXqTzVBI9Gb55mnhSv6zrysPsz8Of+Wzx2QAbmiC4Sz0sKCNIdhbw2e/ae s9ZAaJ/kHsRbQbXD+b/gjesF6eCWx3yPMG3opzzmnu70i5o0JCIeV9AUcT5kxQAiQuD3IXiI+XfP CHUSJ8PCEKqoLRE51Esklhk/uC/1wOm/jByBA0JU4po0jmPpm0Izz34Hqk1QJ3DK/dGXbMmv3Ea2 9TLpaLOPU5x/voiWDlbgNfU6ol90h8e1f7/IduNLw9bUJAiGv4tjvYWzkGL8zZYcjqhHUlRioTyz E22AOoWzlFA1dRmzUl3Nvl5G9LBTkawO6/e9T7mvriC8uiPQAP5y/STz3F5JsHlal3WDMUXyEURk FANMhzTvYC+f3ZnsPDST1KPwiTjw6Q1ihDqFsyID8uJyCmlrOZtLvUyMUTrpmMvyahokbeLYBPM5 BRUBCdRVeXZOZ/USFVHIKk6sLdYpnCqnC9XMpV7s6PZa4Rz5++8uJ6+mppo59n6CYUayXR3tfWwW VVzmuwYxoEUXvbsxV3qGYUOrTuS9lzrXToQBlqiF81Pnkg4jm5yRjbhxqReJhn3FTqsg5HPvCh7R XSqcQB+04/BaIw9whHoR0Ja3BxWfYGCXqOu+OacciXRmqLnp2yJRpZKmnD78pQs0qNmUqZCc6gWi JYkqjofSXq5Gcgt52HnBaYWUBxTHcTpdMCmRooV25IwVzjVrkey+mDRn6qV6qzdGONXTXy7QjvVS SQXB4yhtdY+dt6R++pNyUm+1hxa7ImzuBvHOB4jUdRBWHSffkOd0SCUa3bVeMvxbYrr7Jn93e4JO 0bxoW+dFbjid099YINVL+rf+8uTDa2Auh13UchTmlb+LYLSbB8JBzqN7Z8FF+FhiYMCDRniQ9AsM /ACHeYPeUuWHLAAAAABJRU5ErkJggk== , which is always satisfied since Project III by assumption has a negative net present value, i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAI4AAAAQCAIAAABP89BsAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAzlJREFUWEftVzty8jAQlnMWk8LDCZwTJDRUtHR2CU26lOlooAwdbSqa3z5B fALGBfZd/O/qZT2MJZvATGZQJcxqd799fCsFTdOQx/oLEXj6C04+fMQI9KUqT4MgzUHI3mjBq3cv wcuuvnlApRu3sOQF9l5IGUATLxAgX1nCQxBvK/opS/jO3shD1TYmQh5PUBVJ1mpFAaKItP84d1xb q576NE6XhzEH2E6k7AzDqON2GmQCrogpeImSJxZhtEt3sJFfjI3wA0S0QMKZJEmUb1ckirui62cf rW+ecekRc4HtQKrWqAzaYE+cEZOWGQHWu899kn29iraKJrCryumcfrE3XK7+900Ws1Dho6okUdT+ zjflAiKrywyiL/tsOFuQ9QZ5WbGTXsvADrBdSAvFt6osEhasocsZMYmXpaq1lKeT9fRjFdLsnc4w gOyN8Ab8L6bPaqbqM4lmz9OirFAmTz+jOTFl/LHY+ulZ8D2mnrXr9as5kGWAyzU0cQAIOdjTWewE 24X0RFrs+XEf0/IevDwiJvFywgROoWSljhlXM1tdz1iEdyx0NhD5NbMFzna608s2vXMDJ4MYL8jU vmi7kOpZGcnJXhHj1rGr6vMJezlc/TQZeXOVZU/hSBaBPt0ty/kqxHIz6E+UNStuuWyz40oVUeCa H+0OQ43bA1AGrtOefEjKH9oNQENKcqACdHahlGIAbJtZMeYVMS6PqQK7wtIkijl7DXUevTuekAVC YMD1W4lxgCKwQABZda0fHkFplxcQ/Q2XZMZUYvXQDV6oYR3nTWPoVOoGZ8/2fdRwQRf0CoRf9qDy gukXMTCIeCFVSvXmm3XhT7rG0AA9LOOQ75jGASneX51RHEoBgVv8hkPzZo1IelKU8ZIcsBT6GiZP l9+sAnb69eRSfRpI9Qoc1/084x4Rk3jpaAHa5l76sjdrDIXD7QfCFa8N+VKRXcSfehcu62jcw3Px cgRRuh0wYGyk3GDX48815C89qTojJi/rpH3o+hkwpMY/KEaZu9GryseXeyOVzSAKisi3n4+73TLt vWq8Dp+T97Jz2Zf7emBYC4D+yMGa6SMuFY8jN45AACV0YxMP9b8Tgf9AkB3ZnjietAAAAABJRU5E rkJggk== .

This simple example offers several insights into the use of capital requirements to constrain increased risk taking in banks. There is, however, a preliminary consideration. For simplicity, the example has assumed that regulators are perfectly informed about possible increases in the risk of a bank’s asset pool. But regulators generally face informational lags vis-à-vis banks. 232 See supra note 211. Therefore, they may fail to accurately determine the riskiness of bank assets, which, in turn, may compromise their ability to provide for well-measured and appropriate capital requirements. Even leaving aside this difficulty, the example above shows that capital requirements need to be very high in order to provide effective deterrence against excessive risk taking. Specifically, Bank Alpha’s debt-to-equity ratio needs to change from data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAHEAAAAhCAIAAABhktNwAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA4VJREFUaEPtWL1y4jAQlu9ZIEWGJ4An4GhS0dKREprrrkyXBkrc0VKlCTwB foIMRfC7+LSSLK9+bc0tMymkhrG92m/302p/KJqmYXmRMvCLVFtWBgxkTunjIHOaOaVngF5jjtPM KT0D9BpznGZO6Rmg15jjNHNKzwC9xhynmVN6Bug15jjNnNIzQK/RjtN6PyuK14sBBO+sV5SGXF6L YravsUoyRI9uStP9ujCn4MmKHZvmMH88sEa4fJRs/Xczegjk/NA0R7ZywuQhYFop/09arPtuyqa7 e/vY/p7XBvz63AnADr3wh05h+9n9GoaNIEYtlS74EQPO2c6mPgcYYEoPeGJ7LrZwnuGXfxOPSkZq 0xsEDw7f6ogsWcNwCzaCKLZpvt3Tb7e28WG5Q85qhAHJKaZL+6xfKk6FS5I4h0PxpnPUfPKIo1BG RxFBlJggi8nrzqcXkZjUGAMin9afp4qtX3qzKM9OItXW31+cwecxSgvj5ymrTp+y0kCKZJMnnSLn L5yP8sOsfBJ2uvsTg20RuVJIjcFE3484Wiyn2sD/TqdRBgSn91tlUQRvwQpW/i5m7zfLhtHThLHq dg+Y5gEEya9vo7azy/u2MotTGLGHhCGIYHTY5kSWowzEev7R5go3rirLinOLuykZeG+6Aar3q20V MQui2Fr1/q10gjSMmOgz8yD6zlWphZYrtqxWD25NhAHgVJwyuqrYfrhxMh3ziO261PmBv6y2Y2XI ii2hSgV0+PgQ93658HRQAcRUUpPkATO2rm6rF2EAOBWBbN9M0yZV/VG0QkjpdV0wJ8NiBZBcDMbd e29z4CImseQgJu0eJBxkYPi8P9oceby6lQbwRZHTYedPNqimee+960cM0ZTuRWzFAzcp/e47qQwx IDgVRdspORzInUjNat+mI15t8Cwkkhli36rKEKTeez8c0XapB1GcO89wXushO6bffdMCcKljINyf 6haMp05oPa0WUF18f0cv9uKeHzXpvvFCKhuE6O9P5d4AYtuCe+bE1NHJI+8wEJujurFFHoplkprM QoaiGROLxHtvazA1dBuToAoTY/QLIOqoIac0wEDLaWjeV0dMZk44SHEEqJtBEETdwEbmQq9Vukbx KnZfnsZuJzaoBg4UguI0ZGAbqG6YGP+7bbydnD390LD96VIW697Jv/dkfqyAvwY82NyC608/iLwj xsA/7vf5Sw07z9EAAAAASUVORK5CYIJ= to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAANkAAAAhCAIAAADbHZlVAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABcpJREFUeF7tWjt26jAQNW8tkCInKyArIGmoaOlMSZrXpaRLAyV0tKnSBFYQ r4CTIrAXP41kyyNp9DHP5ijniCYJ1ufOnauZ0TiDsiyz9EkMRMDAnwgwJAiJAWAgaTHpIBYGkhZj 8UTCkbSYNBALA0mLsXgi4UhaTBqIhYGkxVg8kXAkLSYNxMJA0mIsnkg4khaTBmJhIGkxFk8kHEmL SQOxMJC0GIsnEo6kxaSBWBgQWjwuBvXncXNpsF02j4PFsTessK2yn9gJdtW37RlJaxNvh8dCkmCp +vToo9bMXD+hiYvj9Zn9L2P5tRxev1q7mcePXZa/qvsBw/NsX5bbSbvFft/oy2aBz73NgMm2LPfZ 3Didw+UX+Ou8Hv8+0y2IwZ7ykGdZpUX+d/0dmpMf5BPVfvxADMH0mE/rZWCUtifxlQdJs6EOvwWS xrCw34AtCzPKIxUSIRrC/HpdgzcLN4JsO8thFumjwjxYCUdSQbpAAKQfIa2ABRmpxXo+/GSjsL0C pjSek2/otNpaG6tYDBM1ComvpCUEEvXEmNZiElxI8OHwOtXBDKdCwhCqROt5RONHS6uxey36kaBg Je0VDBteqFRNadHwCalFaV+lAB44Ba2G9rSYqkVYczgKnarjSVIdSAQWWIM+eYFI1Gjv06ILD9sQ U65T7RZNCFpSjJ1rMQRJHQZc9tZqyXMi6ZI+C7xHs6KFF3CXnxMT//0IpajR/Tgr3j/FjQdKwOzh TpackykDsvvQrz+Xz/divP6LS0L4Ksun3iqxRsI2g0rKWlYGIvnvWqvBw37Dxfbw7iF88SC0w+fZ WDIdvna7kUFI+JKavefvgoUG7MDj4um0Pm+nJoDLZv5S5AftbkJqEYzOdk+Dx7dvbR1OcPF9tthH SBVGnn7Q3RwU+8aQaJcWMEUVOcy0I/EwHIiknZ9a4eFODThcACEQLbBvJ7+tLeT4QCTaXLhxgu5w aOBK3JM3YfA/QQ0dF+GOxmJ1sdsVTJO4YyAC3UpeALnCHSxA1DSAr3ZaULQvYEfSlnoCSdsl4HBY mVEXu2xWrElw0MP2aSUbMUQzCy1hR6sfbKsRqFEnmz/4FzcAuaybN7HJyNCAQ4kieebTEWpKcSz2 HA0ZUNQ8LEI27b7Jln1ZvIwqq+bZDIp0lJZ9Dub5efasdY74ebSsYkHi28j/XPUWEAqmNh+Lt/x4 4IRmLD3hioOH+GzG2lXi+sg4DFSD3xByBMB0fTrp3tWbVKIQYYuFSSImsm/5Y+5qxjRv3TVkLI7e epGVp6BIFB2rxpZY5+s5MypIzAyvIrDGqPwM8QaSv/vIm0haOclAIgpO193F7S0bHsb56OVBL4ZE SK1XHC73jFRH8UegbWVtd4PDkDDj4NLDMyZPwU24emJREP5SgicjT7I7XL7yW4VXizwvAXHmDYQf AbhyyDBHl5OoDITUFZyfTT5dSNTRXiSdOIvAc1yAEP2tegVgG7TBKeiqHN0GiUahTOZaQEYXc9tN k089kVpkVphvlcyLBcMiqtDmGsIXRarVbmUw3MzP3CZ+HTcuReFIdG15kFwpRQ8ekZya3HxcyDTM ZqqvV5WORBhayG6kGzrM0WFIRCJWLQoLoFUKVF0tppL9RdkVZNkZWkjUa5m6mNQ7crjjqzf+qGa2 zJFkoywICd1fFK1Q3HW3Nv+bnqevv+jEY/T/cMdR7YSbvfcAtLfpL7p4w+1izQSLE8jurza1Np1+ 7yLwNB/6ZZXNt2iy3gx1yoGUqgtJ1dRXoCpqsiChK3rZ2HdW/HY82hOBChmsPieY8KAlpdjPO0Ab EqzF+sWHZJ88x81KrjeiYqpFi5U7qrjovo8FPnUGxSYyWdTaJZJAwM5hN8dDK7EKO75w3oXF/a8R cne5srZSpol+m+e1CruMnWfvPbc6urDm1mvYrua3xtHzflzurXJZ7wek81esvSPucwO6WA/9b6g+ kXW99gDydPokBiJg4B+2yckko6rjngAAAABJRU5ErkJggk== to eliminate the shareholders’ incentives for the undertaking of Project III. In fact, the complete eradication of incentives for excessive risk taking would command such high capital requirements that there would be a radical transformation of banks’ business models and banks would be unable to fulfill “their economic missions,” which is “the provision of liquidity to firms and markets.” 233 Dewatripont et al., supra note 185, at 49; see also Macey & Holdcroft, supra note 2, at 1411–12 (observing that for capital regulation to solve banks’ moral hazard problems, it should be so extreme that banks “would cease to play any role in providing capital to the economy”).

This result changes only quantitatively when one considers that in reality capital requirements have the more limited purpose of constraining, rather than eliminating, incentives for excessive risk taking. Capital requirements are a function of a bank’s estimated probability of default or, in the financial jargon, a bank’s expected loss given default (LGD). 234 See Rafael Repullo & Javier Suarez, The Procyclical Effects of Basel II, VOX (July 14, 2008), http://www.voxeu.org/index.php?q=node/1398 (observing that “Basel II makes capital requirements an increasing function of banks’ estimates of their loans’ probability of default and loss given default”). The LGD is the credit loss that a firm’s creditors bear upon the firm’s default. In the specific case of banks, however, this loss is largely borne by the government, as insurer of bank deposits and lender of last resort, and, ultimately, the taxpayers who stand behind public rescue plans. Thus, the essential function of capital requirements is to reduce the LGD that the public system bears upon a bank’s failure. However, this more truthful representation of how capital regulation works does not change the fact that capital requirements need to be very high in order to be effective. Although capital regulation has less draconian consequences than those envisioned by the above example, it still tends to be socially expensive. Banks may escape higher capital requirements by accepting fewer deposits. This, in turn, may create distortions in banks’ lending decisions by reducing available loans or inducing banks to charge higher interest rates on the loans they make. 235 See Skander J. Van den Heuvel, The Welfare Cost of Bank Capital Requirements, 55 J. Monetary Econ. 298 (2008) (providing a formal discussion of the effects of high capital requirements on banks’ access to deposits); Anjan V. Thakor, Capital Requirements, Monetary Policy, and Aggregate Bank Lending: Theory and Empirical Evidence, 51 J. Fin. 279, 281 (1996) (showing that high capital requirements may increase credit rationing and negatively impact economic growth). Additionally, high capital requirements may penalize bank shareholders excessively, which, in turn, generates other social costs. For one thing, shareholders’ incentives for increased risk taking may increase under higher capital requirements. Shareholders may perceive the extra profits of riskier projects as compensation for the negative impact of capital regulation on their investment. 236 See Laeven & Levine, supra note 45, at 260 (“Owners might compensate for the loss of utility from more stringent capital requirements by selecting a riskier investment portfolio.”). More drastically, high capital requirements may induce shareholders to redirect their investments toward more profitable industries, with the result of reducing banks’ funding sources and, therefore, available lending. Further, restrictive capital regulation may exacerbate procyclicality problems: it may amplify negative business fluctuations. 237 See Fin. Stability Bd., Addressing Financial System Procyclicality: A Possible Framework 7 (2008), available at http://www.financialstabilityboard.org/publications/r_0904e.pdf (advancing policy proposals to mitigate the problem of procyclicality of capital regulations); Repullo & Suarez, supra note 238 (arguing that Basel II has exacerbated the procyclical effects of banks’ capital requirements). Economic shocks lower banks’ capital. In response, regulators force banks to raise additional capital. But a time of recession is precisely when capital is hardest to raise. Therefore, capital regulation may have contractionary effects on liquidity production, which, in turn, can exacerbate the negative effects of economic shocks.

But the example above yields an additional, and perhaps more important, insight on the use of capital regulation to constrain bank risk taking: counter-intuitively, appropriate capital requirements need to be highest when the impact of increased risk taking is lowest. So, in the example, increases when the loss in the gross return is lower (i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAALIAAAAhCAIAAADyGmbSAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABO1JREFUeF7tWjt2IjsQFbMWcODDCvAKwIkjUjIITTKZQ2eTQGgyp46cGFbg XgHHgWEvPSqpW61PSaoGgedMq5NnjkpS1a1bP83rlWXJ8pcRMBH4lQHJCLgIZFpkViAIZFpkWmRa ZA7QEMjZgoZTx6QyLTrmcJq5mRY0nDomlWnRMYfTzM20oOHUMalMi445nGZupgUNp45JZVp0zOE0 czMtaDh1TCrTomMOp5krabFb9Orvbn2k7byE1HF91+stdimOBpN+1JYURlzvDIF89XEHNNlitDrw //ei/HzsX08Z/SZQbMZey/JlnEKB8UtZvrJZKpZ5VDquF4EwCq/SrUwYLVUOcAKm//gJ3j+sRkIt fxHR+YNEsEUv28GSeE7gQwxj2YCfNnibHhBOwj2xqNeSnZEiuK2H1X4S297SPyqq+B+D5b7ZbSAG UsYqa5bJsPCz/dESRcbSp76VFDDAkXI7Z6zKFuK3JM18K37I5eZXvV5tsGSFsNxpn6otVQfX/2n2 6AviWvh01aydUjclILcoxWtbQgfYB4Z+C1uN03Xp4OopsAg/YLrHkcG84vrQObs2gWG0cGhgedjy tyGue9j0NlyJQorBWW8VaxFaBAidmBen0+IEWGRcOYiRkEFgc52KkK42ECsix2+eGUe3Ay25Dm5H rHj7kN3o7n3D2PBG9SDjB67+5l11imor7Np/y03H9WzJVr+RvuH48Vaw+YO5ApmO1GRwQb309G+G dk3o309HSnd6wUgu2RIWjtjzxsGFMTIyiAGmUwPAYLQQ0BZfB1+b5bIGJGv/a1sPX0VFH0mKV7Sd BSlT3zM8IihrcQzs8ZtzxmXttioVaLCg0UK9sf/4NGfFcqb64d1iwjn2ZDrAzwu05ZTh/6zOBKcW AY0gK9Qf/F1lDnCR9NDuz7KwdaJa2EZOBtgWSzMNa9sciMnun9UshzSzntX2sJwZLZBUtsPloGqQ J4y3ew4u3oDBJ5HxCy8yhTpzxqbQyml1ww8t7/63880EtJlspIeAqfKvpjduABUli3R0zJ8yJR1I tcd4q9Fni+ADDoQXY1M+Rcu+m0OkMSO02hqWmLGxdYB6spePDqDrnrsEH8nQgEEnEbsbNzoYt51x uxntgKbT9DTjzsDidPeUQSLUDQZvaDOJWLLhfji+2gxs7ugW7m6tadCxwb3bHk2aGdPp2LkypMdv UeZG03vZZOKth6c70DrNpqYwqFJJq/1uMVgOt6EmNUk+skI03ISFVuOwiN0nVz6oQGYKRnrxQMKh 0AI6A71dEa2ENnnYk4l2Hd+Kdpr6jCKmHG+DG0uWYsi5g3SpisduYWZLKFNJelr+bGacbI5s4VXD DgosBMP9IsJFBqmQ8bLajgZMpIj4c0/9mhDIlebcrf8y3jBC+RI73axZzvTNl42q43sTal89zKcz 9MVI3YwDp9BuniN8sMSqiIOMAYu8vsHBVL023YEm+JxVd1RAJ19dVw9tXhHnMcbsLfR3GuTdRtpl ftUW5/nMEbTLJaU5IbFEsxrBJrxaXUCGxccLHzJOh2eog0HgBkycFiSY/EJom9coaj3epYtopCtM RoozIYHtrWBBXzkTKFEdgYB+cVq01v4CzIjl4dY6XnvDBTBRJqBnu7SoMvGPhlZCP15qKP0/mOEA rVcmnsnlP5Xl759GIGG0+OqYZf9fbBKYk8afCwgAAAAASUVORK5CYIJ= ). This implies that there are scenarios where using capital regulation alone to constrain increased risk taking is not just inefficient, it is ineffective. Indeed, the above example shows that no feasible capital requirement can deter the undertaking of asset substitution. 238 See supra Part I.A.1 (discussing asset substitution). This form of increased risk taking tends to be perceived as a minor problem because it has only distributive effect at the individual firm level. Instead, excessive risk taking has allocative effects, that is, it destroys total wealth. But conflating these two issues or placing them on equal footing is a fallacious oversimplification; as shown in this Article, it neglects to consider that asset substitution strategies might lead to aggregate welfare losses when banks are highly interconnected. 239 See supra Part I.B (providing an example of the potential systemic risk that arises from asset substitution, given high interbank correlation).

2. Contracting Around Bank Governance

The above analysis of capital regulation has shown that even high and well-measured capital requirements cannot optimally constrain banks’ incentives for increased risk taking. And, in any event, such requirements are likely to burden banks’ shareholders with excessive regulatory costs. This analysis suggests that there is room for Coasean bargaining between banks and regulators. 240As made clear by the ensuing discussion, regulators produce externalities to shareholders by imposing higher capital requirements, and shareholders impose externalities on regulators by selecting Project II. In this context, the contracting part of the Coase Theorem states that parties will find it efficient to contract around externalities in order to reach a Pareto improvement. See R.H. Coase, The Problem of Social Cost, 3 J.L. & Econ. 1 (1960). To see why, consider this Article’s introductory example on asset substitution, where after the issuance of debt Bank Alpha may switch from Project I to Project II.

As in the example in Part III.B.1, suppose that Bank Alpha’s capital structure only includes equity for data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABwAAAAhCAIAAABFi1ywAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAU1JREFUSEvtVjsSgjAQDZ4lWjicAE+ANlYeQUsOYqMl6bwBFZxATuBQiHeJ u/kZkswwaiycIQ0hyb7dfXmPIeGck9hjFhsQ8SbQ+KxOnE6cRmbgPyX1OK+SQxOBip+0T+AjjaPe Dyrc12rdPPpTRrJT7y5zjht6qDAEFcsQgE9YFq82qknog+pQzCXRMRBADYgCFWVrUATEuR39qhZ3 rUwiO5wOcpqXvMxlSzA1c+8Km4oRki6o3si3gMqqBkDpZpcRtk5Wx+69m3/cb1Docu5E3e5YKS2u 2HHLWAvg34hqvhSXptvHNiXTUPO3anU4VRr4tN6+a5Fk/6JocYGKge5RgukiJaTt+uFBIBlAm0Og XZ//QA5BoZXeqEGZSWkRReeIT6oyrFNpRKXU1xFhU8ejA+PYLnTc6BlcB2rvq2qC7vb9PrLyk69U 8je/kk8hmJcE0mWmKQAAAABJRU5ErkJggk== and fully insured deposits for . This change to the original setting enhances the preference of Bank Alpha’s shareholders for Project II, since data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAbQAAAAhCAIAAAA+islVAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAACGpJREFUeF7tXDtWIzsQbb+14Ak4rMCsAJMQkTqzQ0heNiHZJBDijJRoksEr wCvgEIy9F49+3V2SSlK1Wm1jXB1htz5VV1dXUpXMaLfbVfwwAowAI8AI2Aj8x4AwAowAI8AI+Aiw ODIrGAFGgBFAEGBxZFowAowAI8DiyBxgBBgBRoCGAO8caThxKUaAETgxBFgcT2zA2V1GgBGgIcDi SMOJSzECjMCJIcDieGIDzu4yAowADQEWRxpOXIoRYARODAEWxxMbcHaXEWAEaAiwONJw4lKMACNw YgiwOJ7YgLO7jAAjQEOAxZGGE5diBBiBE0OAxfHEBpzdZQQYARoCWhxXi1H9XD5taTWHKLV9uhyN Fqu2afkF/DxEp+XaLGmtHBJsLBRE5hkAmZIulAOW0hJzmIJSskxJAqAcPiICtzvHyeNG/G/H3fvd WRLAQQpI0GbVy273fFW0/e3T4pB6n+vL1fNu91LN7LVCNHZ29y6HafM4yW35G9f7rhw+0iFDOXxM BJYzbfc2rypDLPUZn3qwhKzRPPCFVXv+ppprH1nN+9JUcVpRRoHHryatdCthpgfNw21xTCZ+jFhr oYm7UfvpvUV9rDHGkCSaixVLAm6I4WEeI4Mz+CHO9DDbVHU57PG4E/LtmB2Aw2ZGpudXSQK7ndpt F+ewanB/BA5TNKJ1FSqOoinLbtsT1VEzQ3S3bfFW/zy6hqRR6aDfoehCdixeeEg2vuLiGAZdtWQq aVgKDFDdKGKt04eyG/aYtgeXx9LcirjQ6pbhkYW5TQZdwhsUvfyGOeOsn0j9tHjiC3yDdSfkD8vh KFZpwqShwkrsm8N7JHBSr0Jah4ujg57jiOjM32bWHUCdszXPSIc/Mj5OzTdNHSDXdauQJs4EDgqe M4O8GZNFrIi1fge2BRR7whvkArpuHI4CDrZm87lzxpCqFyaDdWSgFNMVzNLXzb0klHTkD8zhGKRJ L7MYbI4EEnB/xg3D4cLiGCMwkaIaOWgXJVu9+nW/njz+34QCRSgBRibPflzYMZHJ+Vh/MT6fVB9/ dYJn+zS7r0AjbZXtn9d1Nb+JRxpFn3UsUkYyMuOSq9/Lqrr40URVr27EXF/+BhmgMtGd2trt3w+x X6rhaDBZv/7RoJDsObu+nTQ1ythHaAUArk1dTD8eN883blWHDJvPtdga+4OZ4ozVrBxhQdPzB5l4 yssQ9kX+kByOYEUiDGF0CUWOncMtgbtwz9K6tDhunx6W1eT2OpinUQMG58P6c6PBlzNFS5GWxhc0 2SNL2QJSST2oltPR5a9PwjCSiyAzRtat9ZvcjlMwbK1aNxo4vPaJ9shWwo3kWm3VSwGupBEfPrDK iZSaVFDC0uVxBvHCRO5/fo4zNLIv8l+IwwArImEyKHHsHE4RGEAS4Z6rdWjMEezNU9tf9z34bEdu qEfdpu8mrhgIC0aO1ZNJk8v1DnNWQAtvI+doErDWjnfU6SIY9CTY44bTnN2/bW5rCD5HwgG9IODg XIKYYkfyKfHCFKcQ/Gvbwkdt17IeyB+aw9B/CyufruUIbA2jBXMPJK24ih9/QUdzAAIT9czlZWrn KLeZkTOv3hFuwClXrPdvc7HpE890OX+Tb8S2w/zV3nFqD0tqNQRH3WZKy8OVDvDL5qh3+tQSUt2K K0FaQtb3424HM3BfrrlQCP8ItBaw9upZ22BamFW3MjOBuZux3KNV9Jk0/ITvauEuiDFDdo3iWzAi dZ/G1/hY+ZwhuG5O2o8fU+po9kD+0ByGm3F3fhGwsu4tHx+HSxMYIhblnqd1CXGUW1AYbrSGRkyQ 8f3FmzfbWu+kNMqtai2SsriOuK/vZ+b2oToARU62Jme9nBLlUZ7GapPO7l6EukYCdipEZktV/thI cHxrzelQq9X7deVFISGmiD2k2VCykO2CYkyr7lMRQpGfxuJb/1GqIhazh+DN0hBnUg7oJQulW7Bq H+QPy2HtEgUrnDCnzeGQYiTw9LUuKo7RcONqoaQukRoBeRjZuQlNykRIhyia1risxIkVe8IDUU68 MzVNk+9j1qrkUxPA7WIPebOZufO1Q5At4M48A4dXfORlEi740DhjV9f+qFimeDIzcUJpspGHucQ9 chjDqgthkjyNFTgkhwsTuHYzwT1M62LiqLeZP7Esij5rtcfp1QI/7Ygm0DwMzGPLvx2lFPj4+0SS iImaliV2CFvNXCCybvIvj1B0a11EafZIH0jOK/Ozdg10FxyIZKDEAjy896Vypu7BxGAezkv8cisP eWXK3jmsN43o/KIRJoPGdALkIdmBw0MQOMk9XOvCCRk89m5CefZFX+cmUR3wgvfF9O21OgJr3Xn0 4/PN1SrxSkb4UVPQWLQdPNYhSxj2he9LBbNJ1prwqRuCJtizj3uONBeQX8g4CDuQgitynhcBzuio i5reve45ujF4rzUC8rUt2C8cwI3AekrYXZAgDScV3Zv29Wei2fG4s/+WZG1JDmck5WI+Re1Pcw/X uvAl8LA2oukkP0tpS6PhvOaZ+8or6v520E/pOqujzd/2ZejHGroEJbVKoZmDCP57xVBnoDJWBNVG /zdDFDOT7Iri1oiWA5ztvJ/nVN8QOaNLZg0Lxlct3cH2EsgjRAXMHY7DKazSZueQYc8cLiyOHsMA h1J4+j+fNviRfiGTi7VH8tZMZ1eAK4BanbNmSo7F/esMYG0EmK5bK5J/A7hA6rd/ofBint022iRz uCue+zj6NDaVJHDqKk9G+EJXkZGDRB4btC0Si5vb146XbrJtO5aKlHTlsfhyjHYyh/uP2lFzuIk5 GhwOulErvtfuush9nfKhjZA5KWYE5b6Ob4NYMsxhs7upzOEGM5TDR0TgkfCk//LALTACjAAj8M0Q +AdAj1MLfGEG4AAAAABJRU5ErkJggk== . Now, as above, suppose that the regulators anticipate that Project II may become available to banks, including Bank Alpha. This time, however, suppose that the regulators will more realistically set the appropriate capital requirement based on Bank Alpha’s loss given default (i.e., the credit loss the public system bears in case of Bank Alpha’s default). Under Project I the LGD is equal to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAHcAAAAhCAIAAABsjKM3AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA6NJREFUaEPtmD164yAQhtGexU6RJyeQT+CkSZXWnVLazXZbpksTl3HnNlWa 2CeITpAnRay7KAwgGP4kwcq4gca2BDMfL8PAuGjbluR2ZgJ/zmw/mwcCmXKKOMiUM+UUBFL4yLGc KacgkMJHjuVMOQWBFD5yLGfKKQik8JFjOVNOQSCFjxzLmXIKAil8XDKWm+2iKB6PaprwAP+OBnB8 LIrFtokeP2pggNpLUQaJK7Jv29flqCmFdVq+tu2erPQ1DDMxbW/6L75qp5eSlC8n7Rn7AS+6Vh2s MfyV8aJtD5XjobBmuoG+qGFb2LntpEebdzr2BAOfBKolnXk5zqbMZike8xkrBgokfNPG+hjb8DsH 8ElNs5/CheGPqbRWwKPNs56BQK3uEWoZ5Y4HxqmMG/i0iWKSOlVBzLMttLCXVOUYaor3sKiyJ2ox +7TJTejcndGsY9SyvAxpzJsfj+87Qm6uZt12Xt7Tee7e5aFVXs/5q/l1Sb5++JHTbFcb8vLXkXOb j7eaVPf92ZgKYnqany/KtHMgvdRvH9zNkDZCZncPpew+ba6V1obVDp5+jomC+Q4nIfX3ifs7fddi NTjj/VquDJoe9NK5MRJkd1ssnr8NDrOrG+TAgjSojY4AE1LiFJhj1A5StoVBzHYNvou4hrjiMXp8 3tTVPydj9zRn60/IBPVuV1Pa+C7HN86TvJTB+tU9rLA21E3FhDYWLnx9zX0ZjFAbQRkLpR4PFQ1D 2m531QG2+fGx+8buw6wpuSz8UP7B207cFsCcJL18pXmw3syFoRV5gPPPZSAiTiFT9rVPb6TASH4w j1IbQRn2PJqnkgqMm+2TpD3f3IgjrN6sRDiyHOAJLeBETypQjyIaQke2zztiZWqM19AWQT5oyFi1 g5TdqdHIrJ00dOipBEJg2wekxtl6D5zV+Yomzs7O8uGOZ/zR2jyxH5cx9HUYpXaQMrs64Dmb5zpy ShOy89DDtw/4biCnk7Xrauc6QsYnKOWP0AYpyhMT7G4VnDGi1Jqln6P2Y5dWfPN3X0D1+zL+pd2d cc3BnctLMX0Fpq36BpWfZn05pG368i9GLa/9tBpWBKc2H1RReu74VqWnV4XYml0UGgWr4UKo8xUX fdqmh9xFhdrCI9TKCju6FpLhaFFQ03f89eFiJmL5/6Sg0WdhLO0HqJ2IcjAYJ4AA3cMO7cw0PCao R4DaS1GWecr6Iy9opp7O7sw+heU4GwUdFnRFzJ0jCPwCAJi9iAuzm9AAAAAASUVORK5CYIJ= , while under Project II it is data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAI4AAAAhCAIAAACA1QRkAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABExJREFUaEPtWT1W4zAQlvcsgYLHCcwJgIaKNl1SQrMdN6BJStKlpaIBn2Bz Ah4FyV28+teMZuTYTtis3pMbYkua+fSNNPNJVG3bivLkwMCvHEAWjIqBEqps1kEJVQlVNgxkA7Ts qhKqbBjIBmjZVSVU2TCQDdCyq0qosmEgG6BlV5VQZcNANkDLriqhyoaBbICeclftlldVNW8CV+oD fB/NYjOvqqvlbvT4XgOPhraXt9PdrKt5TsW6bV+ueyId0u36pW3XYooXwhAD/6jvbjkfsKDkvxbV 8zED6OrF1n62f7aLGoKffYDm0IY+O6Pko2xQQ2IfCIAQcBjyTu3BZtzK+cETG/vWgbaDyYhGRSmh Oh0O4cLkxxhXYc7GfnjH7erNtKlfyHFoigghDdqFHKv+SmP61TqMvGvnJIzWbYw0sSjGhseN60Cr 4SWZRBNLo0gZsaGCHOMZO2DANOALso4jYGmniGAgTKv/4sdIUyH+KDTRiojWB4kku4EPi1UHWgUu zSSYaCeClBElK2Rm//Mw8Rlucn65P1XXF2e2k/91dlGLz29Ty3fL6aNY/Gbq0O79dSNmd90VSiLS NWz3/SlXqXelLCsvm9d346Z5Wwlxee6xX9/JZb16A0plcntf++77pzWqh0M7jkniMhUORgHq+Xsy Jw9PM7F5nPry18xvVmL25GO7+doab9uvjaXNBGoNwh/wqF6YfKHoFKub6ur5K8KtV413QCbFRFL1 cetF91cm0hZGhCaNlhjDTI7w5ZejDke8F2l+ilUHKRUhV8W/mI1OShrRNUga4MRtcqUvBzQ5J9J1 n+LNMJkYhlQYJ5uivO5ZMOhqL9HS9vEQ4yMKFaeZ8PQNWcBJUDxxoILgCd35lWCRsWISyaZ6sQDC 4tBQHaFo6QD3VbmochIiGTQoHDBULI0JOlh4ViJwuwzJotRqkr6sDuSn7ySIG0+xUV1BlelhAQqj O9B2Lshok8UHI25D6W+hVjXzs8fLD3IkVbUFVm6T/RMPUBMqT9uCp4r9gHIxeVjLnYvEgXenRUl9 f2uEBF/KokqoOgLlAZGrS42up8+FB4M2wSThrLMSUyM2VPLy4OZzsfVXB83cwVSKCxfqRDGXSJpn Xk1AbagVnFMiBr1kjF4nMYRrB1I+BkmjwYGgxopQGldoWVuyTV1qdD1QF3ui96BNM6nmiYKfJpI3 4g428enVv8c5NSr0Yar4XAXf0BmLJgeftUxKSaQsfNxzbiEaRlP8wLmqEy2p9fCQhJmL5gNSd8KI v62Itye5ePAd+EpDriDwPQasvPQaI0gT7SXygGUf2QZgMHsj1kNnDStfabRRi6GMlWBkmiFUKSNE rA9DDRc3oSTWhqhgcgTaXTUOwj4BdTSrztCx0e4DeKRQ7XND2rlTgcpWx9sC/VTYYOCxAjzAwMCh pwqVK5Ep0T9wGlH31Dn7MKsnHl1J/ynpXb7/Vwz8BZWJbsLLX/n8AAAAAElFTkSuQmCC . 241Formally, Project I has an LGD equal to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAE4AAAAQCAIAAAA3TN7NAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAfJJREFUSEvdVjtywjAQlX0Wk4LhBOIEjJtUPoJdmgOkTEcDpenSpkoTfAJ8 AoYC+y6OJEuWVkJIyCGTwR1i9Xbf25+ivt0uNyhDKK3KBD3zF6OkPFbpM1MU3GIHyW63jJa77oFS 1EUUFfXjHEj8nlQwZo7wtu3BR/+Qh4dcDccwhldv/OI4AICchQM6PB9yDo2shoQodE+Z5wdmz9QJ DQ4qyP0b3rylg4ZENB6jBOYH1gLuvj9RlmqDCs9nLLVJ+bHFzbkNLTtsICdphtabyXVcf+3z15Ua Vnte8AMbVcK0WbyoTM2T0yWkh02cQb00wyYgbbQrnzI9uMXQ7YIpORxMut37XqC6xpIUqD03mmBQ Ct8MmzjjTbNOVtXVQj7KvUgtxBjpLidRdxyTrJdeGMeaZtaAiWAKDE2NhorcGeDC6xd9RbLZiVzK npvNsZmHWFPNBkcFkw1Wb9ZN/qY9OdwZoBWl4JBFBreMqYGPfGMuSb0MBAln0aAqH9uk00aiMtlY ucAx5z8uIY6Cosx3fzRmSeOhQBz66oCndjeXDdgtUp9QmuMGF1DKupq0bODKt4Vnpzpsz2Bad6Vm ElHuydioegS3qIrqCH0r+LGlKfkFD2610Dip/yiBfvzvt3ImtY9ov7IlUBSoqsBDY+oS+Gf3fwBc t3rcS99kggAAAABJRU5ErkJggk== . Instead, when Bank Alpha switches to Project II the LGD increases to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAJkAAAAQCAIAAACKgUr9AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA3pJREFUWEfdWTt26jAQFW8tJkUOK3BWADRUtOlMCQtImY6GlLijTUXz7BWE FeRQBPbizOhn/WyPjEmBKkWM5mr+M86oqioG6/rx8soOX+tE7Ldsydh8z/+88zKR7wz14Oz/CfnK 7YYt59JyyfprP/8zuZP122SzLf8M73GBhC3LY5693TkIy9VotEKT6Y3S6nSR5cegMSFmRy8f1zuq 33vM8FjNgg+GJSEgx1ZFxtLdBXdiXXYph7EO659JO+AplmJSZHKnNxZeVjhs8RH1AzS7Gx8m+ViS ueKT5KMTtQhOZ9JOKSCYNJ2nyq7LrO0Gakz8jhbhO9jok5DdHL8BcvtEM5Ku1tfPbBepnbcvP1dP ILotXqvgvYzZBIE59nI+pc/jwQIeeqf3PCv2UxWYnPflPFnwE72xAU/ni3Fw/f9Z1291rh6ZrA+7 1KaPenyqOwN1LZkv2TA1G6uVkFOtdsEhO8YWkUYIsOX155tNngbsWME3pDzlaryZYCFG837/QOHT G0v7ydOE8Z/lAlOe7Cf5JyY93ZQ+H34XjJn6DLEMBZatfEnEWwHeeKAptYk6BGfTfXVgrxyk2aZE CNnH0pXRTQnyQARh2zI6LqqKxye0xhUfePSmm49FUfuHOu7nfj4fDeNHOig6tMTkphYSqWoOYeFk OILgSIJL2VR4hbmIEAFbOp5oMK39dJazfKYIbYdCeSCJ4QsLNotNIA0mFv5hhq1bFUgxhHEzaDkR L1LRWFeG8XMa7WvKpotjIEYpEAFbOq7ouKD41Sq/tp+C5ysxQKIbypoBLP1DnsAwfPJGKFIMmXwg cdgR4BuZ5h9YpMRdLToYVXYHMemHpzKRzGyV8jpIgBBtYWwX57VS2gGMBh8zD5FxYCoybxpwPJ1F dt3m49RVWwKjS45vLVXXLllG61Nl6BZdkSBwJukxXzXaEmeJLBPjKV3nvirdEaT277521FOzYmWo zpuAIg1qT78xL6yntw5IAsTQ86X/IYCilpA33RQqFFDzUwUxfbSybc5VUa9pI26HwHqJDXnDR7Sm dA/VSc+PJg3k9eiaL6qBP/NB8xRsA2JKUCctlkT9T4VO6jYCv4e9iV3ocgcE732c6UqXfL877nge NnLxXx2CHwY4EjY0bhswrIaGQzB6vmGfWHPrgpAhHYjeIotJ/P3zyK3Fqj/yg938BYpeV6I0VSM4 AAAAAElFTkSuQmCC , where data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAHYAAAAQCAIAAABMaBwBAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAo5JREFUWEftVztywjAQlXMWSMHkBOYEJA0VbTpTQpMuZToaKENHm4om5gTh BBmK4Ls4u/p5JdmWpRhmMsM2GFn79u1qP3JSliW7ySUjcHdJ8Bs2RsAf4sM8SeYH2KofeozcRTFr wIvNOBlvih49sKFco/4QM5auXyYcST/0SPHPmOgTlyp09YQxvM9sV34tBjJhpKKhG+qaNK+NT97L cro3zhF6MZU8Y1lOF87rVCzoB0sj4G8zeACITVfyBXriqYEwLKfrM1HWClwF84e+7U4IlR1das3K 4sN+m01Fyko5nx7Egn4IPWe9vwU8DrPYvG2z/F3xTUdDytMgXHx+sNkTpi8RocDYYLFbp8fTOY4F nI6DPHiaseUK2ysIZBaKyFSVZvArDkYfUe1ZeY+6I7hTSHW+1mRZVRVoSOWwoG4SJikrjZkrce7J 4rbqXhio8pjRyOplHWJvEP0bVBz6BxcseZWbzc0l5YbYbFrue79jYofT/JwjxEahCrgqpuEofbi3 qsrNLD1oqrFhjh1UiQX3F23x840VOlh8lTl7DLwnAC3VJsASeH4kf7ntTt6he7aizRxCjFRlFzuK wIJF2YBbHcXhWSNiYkuJAO/mGw4HSZcxSImwViqPR5I8rJbH7JXShhddvOOxU40Ybiz8cqtFxZ6n Oi80mfLxbaku3pcDJ80MjXguBNaFgpQ3nxe+RtPUNkwcgkI6j+rFJPix5hpoyJEnDfQGjjHLMmjD ZFq39U/7jlY5HE2JTwGatdW1j54oD3Fr3+7a91v3NQ2FePA8C73Ixo+0UJZmyeh7sW6a/jkTvqN/ cEDsMJANpjgX4bvrCh/Q8A1JB9L/TGLnWy000a64PwFb4Vl50wiIwC82NE0FWsvoPQAAAABJRU5E rkJggk== . Thus, the undertaking of Project II determines an increase in the LGD equal to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAJEAAAAhCAIAAABWcN4BAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA2RJREFUaEPtWTtW6zAQld9aEgpOVuCsAGheRfu6pCQLeDugcUrSvZaKhngF eAU5KbD34qePZY+k0cfGIegcuQqxPHN1r2bmxmRt25J0RcXAr6jQJrCMgaRZfOcgaZY0i4+B+BCn OkuaxcdAfIhTnSXN4mMgPsSpzpJm8TEQH+JUZ0mz+BiID3Gqs6RZfAzEhxjWWbNfZ9syvj0Qcl3k 35195t7Y7Lf7JkbVo8JM/+fJruNGQb05dt/rt/KiHu60dZHrm1UXgLVqCvsy+EjIZwdyBR7cUkjc sDWO7CIAw+DarMRoh6ekYKFIF5bFZY/TR3mULgRf36cUT4PocKlzj544YfyYq3h+HLngosfKAcws myO7WgcWzTSIGAkob1SznvhOM150g2YwoZ5ljGauOBM1cyA3NWLfzFfd8qgznhDeeFOR99C0UnD3 1mkYkzd0nt29tC93vOnRTx9Pi77/LW5W0xr/XHF82SXy5vNEFbpdgvXL25xUr++XnLYDb4w4ySGG udn/2VWbI+QW3RrKG9Vs8fCYk8N9tn4++ygp3w70+PwWen7hmimOHTk/XNW5/gJG76MjeNNjlc+7 agqPgjc2z1QPYm/6ZicUBZ73RiSs9wR31KCWOYxoBbk6CaRbsgDUnIQhV4ixwnlDW2DXuKFFCmFO 8iY1kxZHwMXyowYIfikgeJNbjdR04oB/1Q2SpD8vigu4kMEa2njDNJNa9VQFmBFoQDXNOg9mqBZW Gv65GhYnqL7gIhrWhlwu82MbnRWEtma3aqaebZ+tVXgzPcji6R8tmMMbeCFSbpe71dE1U8Ux802R 0DjeUYIvQJD3C5v314rkjw+Dn4Ixym3mvNYBLwpc2b0bYgaJnD4tBknjjWpGAZtvrAbPRd/M3J+K ujOSbHm/A/qkshvErQ1oHXG8W7Is8CAHT4mh/xdYYCUkc3muC/V34dk1+MjRrs8VIasb7ESZvNHe 2Nel6DD8b6XVKmUMfzGoc975K9aYYtovj0mNyYm8jxg0LSbkD8qOt2SMKsmy2iYx3vg806Y/0Aj1 Bdb7urjDWPTFmUCZZnf5WdYMUDfsvbboEtmhKZR1Bq2deh/cUTTDfRnA29XZ1B1c8bnrIv/u7DO/ 1586mdJzIxjIaHWMWJ6W/gAGUp39ABFGQvgPK8uUqLBBBtkAAAAASUVORK5CYIJ= . Assume that the regulators determine that the maximum LGD the public system (i.e., the government and the taxpayers) can bear is equal to . 242The level of acceptable LGD can be interpreted as a function of, for example, the targeted value of the FDIC Deposit Insurance Fund (DIF) for the current year, the level of national deficit, and the shadow costs of bureaucracy. The latter are the transaction costs that the government bears to channel public funds to troubled banks. See Jean Tirole, Overcoming Adverse Selection: How Public Intervention Can Restore Market Functioning, 102 Am. Econ. Rev. 29, 55 (2012) (suggesting that the magnitude of government intervention must be balanced against the cost of public funds, since the use of these funds is not a mere transfer of resources but implies high transaction costs). This implies that they will need to set Bank Alpha’s capital requirement to reduce the LGD under Project II to . That is, the regulators will need to demand an injection of additional equity capital that is sufficient to bring Bank Alpha’s leverage down from to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADMAAAAhCAIAAAD73QTtAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAfpJREFUWEftWDtywjAQtXMWQ8FwAvkEQEPFEaAkTTrKdDR2iTvaVDSBE8Qn YChi38VZyWt59bGJGGeGycgNtvejp933tB7CqqqCp7xenhIVB+WRubfG18zXzL0C7hGeZ75m7hVw j/A8+681K9M43Fzcd/c3EQPzrEw3aTkQUvhy5Nd5reRbn/G9bmJJ0VqqImE6DNWh8bU4QqDpy/3w bQCxIgye+S9AEo8ITQCWCer8JB91JYDNW8hDN6usodcG80M3y8+PPFjvthFuP9ruaAFZcmxM0WIF 0PJb4dyv2aE6zNqoesmlfHPZhOFpiTVCNyvP2jxw9yUhB0Fxy6GcbUZnhHXAZf+as+SthQrLKMjx a1tUIpuH8f7WtxJX7vwKNKObfwRamb5nAVstmh515TAUoPBBV4fG2ZqhTMrATn+Vdn3cbBjPI7gC TAGZ6LgPCowaiZbQfA+c0JQ9f6tFCzJUaGesqlVdg3TLHVLlCbrB0wSmAqLtEXqUnazDYDQxDjBC k2g87ZfubymGCgDJmjOJTUZg5qyP6aEuxDkdI3khUrGW31eoiIi0XlyT9Hzq1w8e/7zzUEteaFLw mlmSFXq3bOewdDYJ1d9JyWQyA/TRpPBAHVs6dVWrGahPuS6K2aaXqs17yuodQcMaB/7WeOTk7YgJ /b9UztX8AZHE0QifDk3nAAAAAElFTkSuQmCC (since data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAJgAAAAhCAIAAACqZfXLAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABGlJREFUaEPtWT1W4zAQVvYsgYLHCcwJgIaKNl1SkmY7yu1oSEm6tFQ0xCfY nIBHQXKXrMayNDPSSCa287L4yQ2x/ma+bzSaz2K03+9Vfn4+A79+PoSMABjIgRzIPsiBzIEcCAMD gZEzMgdyIAwMBEbOyBzIgTAwEBg5I3MgB8LAQGDkjMyBHAgDA4GRMzIHciAMDATGKTNyt7gajWYl MgkN9P20HJez0ehqsTuiE33iPVUgAcNErfb7l+temdotZn1xf/2y36/UhO+1Xp3tdTH9j2V41lOy avG8rZvrP9vnghqdrkk39rFmu2jQqDtgim+DOaAUnZbwzXMMnAycN/bCJxwo+SU6y9lp9ZbAa9YT nbEdFg3SpGwQHSxjAUcYFvCd98Ob6YNfjBvs8pAGHZUJPRf+6sWq19pgZc0ta3whVujQOJ96kXDv 8R3meI3sA6G5VfxcjCJ4eVbJe80SwCJTB5LO4JGzJBO3K9AYPcsIj08dlBBtyL1rcXOQef0r7lud a1LSp1j2PbCOC1AbkqNdLFN4q3wAQLIzXraQSECN1MXg78PYnT3j88vmw7u4OKsHuV9nF4X6+DLi YLeYzNXzb6H+7d5fN2p6l66M2qO6dnq+bT83GmfD7Abvy6f5pqC+QTFMlurx7X2xeX0/nu5BvBCM uDPl21Kpy3MXq+s7HfblG+hFQexUox1Z44fHqdrMJ05ClLObpZo+ushvPreGOSDZGDFhXJHNgdzC KNwFVTvwpJY3o6unz1QMQB/dfOjy3Ukf7RZ/lqq4v8WN27xrFexth/Mb49NDvok3XGT39aELi0sh O8Bkj386yFWHlmZ6kpHRvFpGj7uglAZqK5xKrHtVwxxAhdMyjaUsVVSjR6sgAJA2T7UE9Edcwmky VZIzYRu2eIGUpBKfHugN3yMMKIpFBJNUJzghAY4rWupw4FpYwkhRiVRvmffY9mtXJO2sFN4ugRRJ juwCLgMRD2qciJ5NUaIn19qVR8sXWtG8S+SUk4PxpG2XkR1imcL7vUDixsQaWc7O5pfroABV8oLU V13S4mKIaByotHWhhZJ8QIUZP6z0gWlKePCAooo/lWtRU63KIxpjJGAzXAClnsbLoSRehlWGZ4pm HUgtJEBHOBlRzqz9ijkrRo0ilUuu7tF6UNQ4VM/Cb49qTUV4MWfcA4HDmOD7Ss9kvXHXjHdaL6NK O0C0wLqhyDALgMxMPfSDwMxI4G3wqQoG2eJUxYqXCPTrza88/BPdO/X4vYF9w/O2vrHgB7M7H8xR Q68WjHG3qn/eSNcF+IEbWklroejRKimHDidqAi+vUcItFUXM/HU3O/5eCC5p3IC4HGASJa5ig5sd fkEoXBChc74K4poRXQtUTUNtDlKBGOo5jvYuDU0yRlEBRVDLGj74/Gi300Saogo7xkydke1cONas /sPoPO0Tb0+BPJhFkZ4+gR3skTgh+bXU2USfeE8VSFuaY58xnUnqvsBxvh27+yWvMNLNB8i3PPR/ ZeAfagqNE3/IDiAAAAAASUVORK5CYIJ= ). As a result, in order to meet the data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACYAAAAhCAIAAAA6Wk5BAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAXtJREFUSEvtVztygzAQFTmL7MLjE+ATkDSpcgS79EHSOKXV5QauzAnCCTwU hrsou/qhz8ozCYNdGDUIPZa3+/bDUEgp2X3Xy33pkG2mnEjzWdhZ2BEKzOUzQrxbps8nbP+1KXb1 RHIOr32AsAw+0bjO2yC67dmcu0t3KFl56OJjKRGwizaLUKRURvA6vIKRuvWNnTsppTVFTzS3b0ij QOkoDKUK2VoiHe596yFSRD0/lG8DZwYlc1kd5bHScsDW7ZPCqk+CsfWSW6B6B05xMhWYQ4GSv32U TLwWm8/2b9XaXy8Q5GoRWV2uPZ5kUYyS739Qy0aIBqjHtMliNZRS6r5BrbAooM4/xDttd0a5NHX7 31i7tgmSG0Zq0LR8+P4bonVFcCO9fLlmrGm78BGb3CwKlPWOEDKtCoJbJcdzLqzRLGoGj+k9bLKo nXQX0n2ph5bpzPQRGlUDL5p2wZDx5xk51zxjYiASqJ2xJhJyiqZzddTJA74kxVP87P0CgTUuO8Et /P8AAAAASUVORK5CYIJ= outlay required to pursue either Project I or Project II, Bank Alpha’s capital structure will need to change from debt plus equity to debt plus data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADMAAAAhCAIAAAD73QTtAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAgNJREFUWEftWDtywjAQlXMWQ8FwAnMCSEOVNp1cwgFyAxpTQkebiibWCfAJ GArsuzgr2fpZK09UJOPJyA1jrXb3afc9rYekbVsyyedlkqg4qIgsvDWxZrFm4RUI94g8izULr0C4 R+TZf61Zc1wlOQs/3e94TJdnBL4c+VNS6+S07NeNn7rIxB7M1rbCmhW16ydXrBTOThldpeDIZFD+ C2nFq52+c8MhicR9XC8ygUpZO4w63CC8MFNAppD0yEQBDRQ/qwalEG8MmWmzoXRIzC7xFZRn61N7 WvfdbY7v+4qWt13qIzrLN/eiPm3HhAARzQjpfKl3N887nGkxM/xni4wjS1/fMnLeJKvDww3ODvuK 0K3EiWzguC5+3Chedj1DlfqoAmb1qIc7HQU4ZYVCm/S0OgZll++8A6MKUNpwiGyzUJIWEZ9uukSk MloE4S8ai0QGqyNS6Wg9rsysKDjzbGTgYiZHyK/pOrhojGb4kSG6R64ZsctVQLq7gOF89QwDTk5y fzaEAKvNx+imks+AOiyf7ZelVpdHM83XZ0UyQMZyZCZ1WkHIWT8qQpZzr1K9CoXZJzQsxcTy1RHO 5xPdB3RT9QeKyAlgURm7BFGeO423bymHXYZ2HKoLNgieDRgzyGzNDc8g0BHsi14yDuWklceZIq4C /IPvby3T/dZI4r9UwZ+X36KvL2vt3bJGAAAAAElFTkSuQmCC equity. 243Letting data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAA0AAAAQCAIAAABCwWJuAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAMZJREFUKFNj/P//PwMRgIkINSAljATN257O6MWwjRjzrCaUeqKrA+pO347s lju3ruioqTAwAO1FAtvSGNK2oYmABRiAMiAAkYUpA9JWE24DBW5PsIKwmDxngqXBAGiHlZYqsq0q +Uf/H80HWgty3/YNs9ICPIHKtq5iCPMGCjKoalmBHYUAQHVwU25fOwaRBWrQAWlEBhBbQc6DOg7u JBTvgP0Lcx9EP5qHIcoR4YIZJMgGwsMZ068ozoOrg3sCe8IgnA4g+gAWBcVJsFygEQAAAABJRU5E rkJggk== be the socially optimal LGD, the required increase in Bank Alpha’s equity capital is determined by the following equation: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAKAAAAAQCAIAAAAeZ+MPAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA+RJREFUWEftWLt24jAQFfstJkUOX+B8AdCkok1nSmjSpUxHAyV0aanSrP0F 4QtyKGL+xTuj5+hhyw/Inj1ZVUJIc0dz5yWPqqpiMC67hyf29rFKxHzDFozN9/znjQdFvjHUTxT/ S1y62KzZYi7pTFYf+/m3GSNZvUzWm+Lb8H4YkCC4eD9kLzcO12I5Gi2RRz1Rpp4+Zod3m2EI6xEf /IQauPqwu/w1ijzNB2mC0nDc5EZGVUjRVZ6xdFviTIxym3LVrUXzd6sZyBRDCckzOdMTCy/LqVjQ wAFHncySlj5YT3NjCmjLp6ZwbdXKGHyTlGnfq7+4ZmBtZIzgy9cnm9yRcgs5mh8XJTk0wEGs2HL2 wN8zxhkrt0zkXwARGHpiziTzRfr51RSZl93TcVEafabPwLf0CYQYDwsDqFAn6wpUPl4i0/Vrui8X x6c+aYTLTLdvN8iUHh3GyEhweT6l9+NB6cY6fNm9HrJ8P1UhzGWX58kjX9ETG/B0Lus1uPw+mhZB bVM6J6u3bdp4PHK1Yvl6X+aZK8LYJFnRdhPcUTptd5Ol2lG6n60/gRVWGFcNY2Qg2AvgodjgMBKv WI7XEyzuyDmPUT2xQJK7CWsIYeD3ZKUY5q80Z4CGK4FGzOs/jPxi6aWqeMIJwvk612mlqrOo0XqQ LCV3CNUUv7AotlAjyy56KKf0POCB8/M26f2xqngkY9LnCVZPhiEaH1JybAdoLR1y//lFJhviIyCf HWZo2tlnMLn1yBi+znVaTvfBAksqJu5QfQIEqJOAqZEDBDt+Q7QwnjU7yPv7bSDiQSJCkJzNhtXG WhfnPqT+xdBwa0w8CPjpYnNcPPPkNr4XjaVYBvmi68yzuOe0wxJ+39rzohtV3JryBVfwlQ0Q7HgP QTKeBd5j2l67FwNHVTCA2MPTo1fDokKKGXZI3iMvHgTI43JGs7PWlRSt6V73EpZelKtWWFRnyG5N LSp/SAaGFSw6brW9gWnZ5lBNJcG9K5jHBnFUtPxVnNYtesSHsF+nHV3cO/QOLL6mFaRtAE2mATLa F1OiDdV5sw4wEQwkK9isQAJ53CFlIIOaY5WMbBsEnsEtnnZWBLsP2CxT2c5+3NbLxUeutdd9B5MN 6pEur9EWwgV3xHBpPC17f7hfA/w3etRgrkzrQd/3a4P9Vq+zA5PfNTraqZZg/ytG9PYhFwt/6Oio ZBvkznt60NuEMfRDRy0RChQJ5k57HeOBpB6CwnTyoLKkoc/29ffOTAYOXBdfReCQG8XdjROMDBMY HfuduYrjhezc79Q1GPvnZUQDuBIE80eVS2eedSa4l8H+89vLbC0P/QHSKjaqyMVtRAAAAABJRU5E rkJggk== , which gives data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAJkAAAAQCAIAAACKgUr9AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA7NJREFUWEftWDt64jAQVnIWkyIfJyAnABoq2nSmhGY7ynQ0UEKXNlWa2CcI J+CjCNyFndFjNJItI5nHfvvtqpJtzeufl8YPp9NJ/F8XInBcvbyK9+9pBnxgvxBjIYZr+XjjxSU/ 3ljWP8G+XMzEeKg9l02/18O7mZ1N593ZopTy7uFLiJ0HuSZKZmCVE32CNvYgsnhZHW8IkScUH3HF CC0/N/n8lknYhIzoj/LNpwIWaqxdh2VP9JYHelHkHnr8o0PZ9ABca+iIt/lW5HpHG8XUVcpVqZU+ kqvm4zCAd43P2kjPHp8K9cXVWrdoZCw+eYG9kjtBMnFUQL3kOQVqzvwc7Up0hm8XSlJ8SQJs6A2J lN9dYqaSRK0tZH7cmrhh/HwvKZPhLdPPGhAJiEfuU8UjQ5QGIlZjy8nb86HIt/uDk4y9545+zqZX aufH1dsmL9Z9zVdJOOy7I/mGNvhw/PqwrcjoZVTKpu/Lnq9vQh3uUZMzRNlwLEz7CbUCqKhKUbUO +62FKEF47dEEZBx6CQL5EriIStEHJLfdJ2zq5aTa7ExPUZ2F1vkWA+ZrOMpJZ9ZFsWjE7gcaIm2k rlYBo3r1jSRLXlU+kgU4s9fIEJsjd+XxZycURNdY8cgwadlTV6DO2pfH1et+rhOFmQKsxWaAXhrs KD2JS39dW1bU1bxhARwQyfJG9Dk6naRYuP2dJCFtAgysteZAOySrfEhgQ6ZDpO2Wv1hWXsOBlsdF yGhflouPsdKw86wat1zIWnXIIm+HWJ2pEMlY3NBphRicz2KHh7LWvMLk8gtcXLVw+cR6pLbiu8Re kSIo9b0YsmKj06N6Tb4IGVVjy8mAl1cKS1Y++mvqbszVpF9SjYWMMIEBkZPW7rS1JtYWs21lGoiq FpwPFAi3fwTbX4Qr3bnA/oexWjl3H7eGXYIMQPKIDUrYe4ipvYgWL0MVg+F7FGqVkGcZATP2mXuD 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What effects does this mandated change in Bank Alpha’s capital structure have on the shareholders’ investment and the costs the public system bears to avoid bank failure? To address this question, start by considering the payoffs of Bank Alpha’s shareholders—measured here in terms of expected gross return on equity (ROE) 244Here the expected equity returns of Bank Alpha’s shareholders are measured through ROE to make the dilution effects that higher capital requirements produce on equity clearer. —with and without the additional equity injection. Under the original equity ratio of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAEEAAAAhCAIAAAAJYVFIAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAApVJREFUWEftVz1S6zAQljmLQ8FwAucEeWmo0tKFMmnoKOlokjLuaKloICfA J2BSEN8lb1e/q5Xk54wF85ixGki02m93v/1LcTqdxC8/F7/cfjR/9OH/IHHkYeQhVwTGXMoVyWF6 Rh6GxS/X65GHXJEcpmfkYVj8cr2mPLTbaXG3z6W5j548iD+YS/u7ophu2z6+nSkDv4HwvC+9d8t3 /T38OW4qd0cvlAi9Dm+dGkSg9x2ITnG1OToNKThhrABptAZQpFEaTRlooSVu4J8GYrIM23NBisYR /YgyH8w7Fzs0BnywNmsfJCnK0MBm+Y1T7H+KiFtHQhcQIURUmOaOQBlziFfGumg9zHan3Qwi3n59 gsVXE5Jmk6tKNC9vKqv3r7UQ15eluZ/dAH79GraFdvtYi+UN6owfgwi38K9CD04KDnwo54tK1H+K 6dOBPSsvr4VoDscEcMRFlPz84nXbvr001ebeGpZG7CrmJBzyUK4+kMGmrhvwhXZXFdhH20za7e26 6cBBlsIjXVjMLV1diGd1JA1ncgkZVEUJjLgpMdvBl816UqhzKxZY1SR9emCGLshHCcQeCrkIqwfd KwgbSJI9H3MRVAjVeDwAS8zD/dOaseDZECL290LDhTVdrp6Bj1hlQpFDVgibFvFy8XuArPvlw4ok UmBjFyIRTsKBDzA/ww2DWaJUYUipQTIfibe8ceATdIE3pP6Inr9JODIEIPWx+7KmrxMpPsFki6Yz jg0lPpzJUqBnQBKRzjOTzHE4nNN80YgNRzrZ/AlMdga+GdCJn3yEofYeeruNJsLtBhE46YMLdbif sJXhnI9oTLdCzfw5SiOy37i3Jnpq/7bTW3JgDNLP/81CLmiaS7l02tUza2amrfsLUs53a5Bg5EcA AAAASUVORK5CYIJ= , the shareholders’ expected gross ROE is data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAPcAAAAhCAIAAACKiao2AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABhFJREFUeF7tWjt2GzsMHb21SClyvAJ5BbabVG7VSaXVvO6V6dLYpdW5dZUm 1go8K/BxEWkv8wiSQ4Ik+B0pdng4laTh5+LiEgRBzYZh6NrTGKiagX+qtq4Z1xgABprKmw7qZ6Cp vH4fNwubypsG6megqbx+HzcLm8qbBupnoKm8fh83C5vKmwbqZ6CpvH4fNwubypsG6megqbx+HzcL m8qbBupnoKm8fh83C5vKmwbqZ0CofL+Zjc/lw/HjrD4+XM5mm70GAD/g7x8HLWXmU6IFl1C+4BTJ x8uMp7NDLzPqZJh9gFOIO3cbHcuX9wf2X/Ph9W5+7jnp8YHuVfc0DI9XHwPgc8169TgMT93KXPQM 4vzuFdx0uF/68e5/7rr1f6Yjz06vD/CnoBUoG17WXSdVzr87PK5f1O/Ea+ut9oDTDSZyxxJOswFA W/TQEOxOozWqo9sAC4TCYlua9j2A1lBkFpM0Mco7NHqCS4pe6fYChoMEeqZKI9HfyqCXcrqrWSSB jlS5sEORyKfAlPL3ci6rLV8xoq2zdnwaR33wGmITwOBsMD4HBqCMJpeG+lE0S0Ve7ImRDgLtFCZ1 tPEsVVLlBMkU7wHMShJcJ9bcIdeHABeTK3SkYbg+1UOzdwYno25IlTuqtgRryddojhk12ZUacM11 NKxVrfog/OOomG81KHuJ3UItQfTeNbTEGQq/i3YKk3hTdWTucoZ2YFP9ZNMAZiErGINgOOT6IOAS YmWfiE/9IysjqRrL8fcbWztfF2gzW3xddv3zL3EwhbSvu/ii8verb4yV3U91aFRdodfbb9Hp+LDa dvf/Ejn38ddz362/hbNxlvWN+TokgN7cnb3EJ4v5lwuc9cSQnyqHHNFOZZLjmd/cLhX3EYTA5dJk OYleNmwSw0kE5gBOYTzs08Dx5MdWkkGpnEujfz94+hOug5ajnFHXw3svV4PQ+BN5soVW5priju12 17PLH+8pNAQMhQWpVlAUedlkfrRTmRR4YBS/O4xVzPxqHzsJeuXSyWc4kcB0wCWE85UWi4oQVr/v uuXtDQRjsl4ugvN3VVMEjfYBQBCzxwc+y7jOj/o8Ru8J9oMGQiWBbVT9btczX5TWErmh65dA0QYj L2FcytCLdgqTJh4dRLw4wVwrkPttOg3DnZ9ACjCqWKtyKP6QUMaO+1TYLLYwWWiib4WuHllK028X EsGqu4UDAEpSguy9rFkYZs/1Tihsvxk/6WKvtofHB2poyExEXg3D5Std7B+H3MJkoSc8aCcwmbvq eLYiYhd6vPSyNlMZzkXIJww90TJ2sk8hruqA77v7lGVZAen1pnMydWwhbIpIqNoWUBgsvlHti+2F rL7025XcKviuHohUstKSGdHZeoLJYrRZyMGoaZ5w0U5hMkdGnv0yRi+booxhgY0gMAd0VttEn8KY kEagbS3php9HfxUm6GTTyqxH+OjQqROYDjbytEyTjzO/e2IxHZ1vY+TsN3w92WE8C3lsDu/7ENpy JiMbaVa24kJPZDiHQApw4T7J8Xp8SrkBp+T8fYrKRfTXd2k8F0Oasw/eaGLWlTx04uoLr9+YZ13G hpuheNaRYyZb8tdvKFPZb1R6lIE8Q+TpaMuYhKQjYjwM7GYr3AaCXq6ZIobTCPQCLt4nAz51HWWz 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Under the increased debt/equity ratio of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAG8AAAAhCAIAAABY9WIrAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA5tJREFUaEPtWDtyIjEQ1exZwIGLEwwnsJ04It2MCU2y2YabORlCyJwSOTFz guUEFIFn7sLqL7XUama9MuWt0gQ2jKSn10+tfhLV+Xxm5cmkwLdMOAVGKFDUzJkHRc2iZk4FcmKV 3Cxq5lQgJ1bJzaJmTgVyYpXcLGrmVCAnVsnNomZOBXJildwsauZUICeWn5vDel41XU70q2B9IdqZ d/qwbtbDZ2rYNVU1/9wp/oU+/7VYPPslAFnu9fuwqW5713Lu2zqcG3YwfZGOfGDcV/TDERzNJDfG /KZwaqRNsqKmg7IQsWtwxic1oOI/fy2/6mYpskVRmnigfldP5PgjxwHRIAPtehLhiT4Wh6CtCSi+ mMSig17h5HQwdkVPYwXAsk00cTVtZFpNmahOTX+2kN5oNQN9w3FGpQvJEospaCK0rVjplZFYS/6H UjMRu1XPhiXe8M5o3bzbnDd3cgvzT7+fJnY396cD5/Co2j7+dM+rQ93+cDB8GjNjGnVY/9qSkzva jA3r76vDcu+T95G75v7Y9ptHKoYg9snNTPce3o9cu9upN3h6W7PD7o2rOXlY1Gx7X82fTxS4sE5B 4XLYF2SWqtSLB7dIo9ZleNuBJSBpi/VKKy+1fPGyZAyB7nWrM0nqejj1yKjIheIy4zlUsC3Uzqyt FZEV3S9miVpG7HTcnxw1gKi3ou99jhpvNF/0BiVLvmqEtQmWVFeBhQvFxosHq8n5jX6MkUehJOOa EzJAl4Qwe6eZYWbeBPZpiiwQVirLB6S8ympJOHrdtsqHAjX5ENIIg0XBzIXOTzobkrlJDeODAtoI jF7E4CDo7dW0miOs1kwYu9Dk6YXv3+0reikS1Tb9EAVFDfpgyWSiZi1/koWOpM2YJH58n3K78x5v kbTtRsF1zXQ129NmIUq6dAKuJr9exPdJZVnCecDNQ5r67EYbCB8JWhGzA+yUN9CqYGslxQxPEgRt ZFUh8TGuo1Z/Lr3fnD66BruHeWHpa5CuKWKbegsW7PpwB2Fne7tjkocyoubjOx0cM8ERTx6L1U73 aZuTOeSC37zAeRNyjmq151/Qa8xEsm4G1QRMC9vC6gJb44HhLTBVVH33NYnj3zvQqkbRtlcdjYYA uOGWFVATrbEuAE0ZRBS70IjjwjW7EGbujlxjTmbXIJ35N6SxBWl0P3lm/+uT/mj4zB0rvmSZIXPC cRuY7hZ96oKYc6ocWF87N+WF/r/JTMb+AKhpPkPeAOLTAAAAAElFTkSuQmCC , the shareholders’ expected gross ROE instead is data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAS8AAAAhCAIAAAAHwbpLAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAB5lJREFUeF7tWz16GzkMHe1ZrBT+fAL5BHYaV27dSaXdbJfSXRq7tDq3rtJE OkF0An0uLN1Fy78hCRIAORMlYjZQJWsIEngPIAFwPDkcDp18BAFBoAEE/mlAB1FBEBAENAISjeIH gkArCEg0tsKE6CEISDSKDwgCrSAg0dgKE6KHICDRKD4gCLSCgERjK0yIHoKARKP4gCDQCgISja0w IXoIAhKN4gOCQCsISDS2woToIQhINIoPCAKtICDR2AoToocgINEoPiAItIKAjcb1YtJ/Lp/3p9Nt /3w5mSzWQQH9Q/z36VSrWbk5bTWvGKEGZ/ch4SWEM44UMm0ZTlldQ+Fpx4Szcfa0U//rePhxf3Ya 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Consider now the payoff of regulators (i.e., the public system), expressed for convenience as the negative of the actual LGD relative to the socially tolerable LGD of . 245This is a simple normalization of the regulators’ payoff, which does not change the regulators’ preferences over the available courses of action. Under the original equity ratio of , the regulators’ expected payoff is data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAI8AAAAhCAIAAABvF29aAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA7ZJREFUaEPtWT1y6jAQFu8skCKTE5gTEJpUaelICU26V6ZLAyV0tKnSJJwA nyBDEbgLTyvLtlZayZIN46cZuUnGllafvm//JAaXy4WlJxIG/kSCM8EEBpJaMflBUiupFRMDMWFN sZXUiomBmLCm2EpqxcRATFhTbCW1YmIgJqwptpJaMTEQE9YUW0mtmBiICesVY+u8Hg9e9h02v38Z DMbrs2qhs80OcP7DqS3VAha7SWNysf/csvnfxfBWLBHOcKulbmaX/xoZ+JxWGctWJzTre44Azr/r rzC8etQPeFnTqsNmMZUCUn0ol8QrCjB2EIFMtBmu0uEEQvHGAlckGBJmuXzwl6+vElKsWIES/NMQ 4ZPyxWFTAK6U1N2m0LD0Jm19t8aBTLQZ3oSttGnjLVAtjdTSwwXRUi1BZUG8qQ68MQlGCjfYLKyW 65nGtBUoB7HGZBsBQuZ4YKt9EXm1nBlUt87rN15aniYNaXmyuWxgzPn3h2tzP1KGj+4zln98oU6C D/z6yLPVq8tuaZPb4v8W9qkHih97uKuK3+SJa7v9RM3PcPqcmSBuVmsqwz7YYLCdtxC1gFRTLNg7 2z4Oxu9HbcPDuwfG8uOpiYf9+zLH7YXdZoMtYqMw4+cX+Uc/cvlh42gdvAVEsiWNoTqCy5LIQ3Xm k4UTp0JrXqq7DLrUqUUAJXxknxpVZ1N991pnY/gGkcW9CTSR0NjKEkLwBrEFra3r0c5AlHtDdiq0 4FFWt/aTDX+ZL0fS+ow9g3xKopJZ8HlK9O0Wm02R6v1dCzgxD9Z0PQfygHEFAjFqG2+glidEEcmI acr1QLPtY3VKHi4O9e4PU6ZXMjML6kZlt6nY9NYDBp6OeRPqIHs2Xw3X2ImN5i2gbol0Sjkk2sBw sQO9cF2XI0Thy5RAgralob2AqS6bmD065eNOxyXO1aNEWaw9toq3ALUsu+QbNO+bSH4gjtBtBbxQ xatW8Lepg4KmU/UVvQ9TxlNpwjPNtIvGAGxoAYU37yIpC5NR8asTDc+BUBjpXoQ6pxKHN4nGy6al Rqudja2M93XicmCz3Bxg3oJOx5Z7G62R0vomshF03Rvhy4rCy8w2T3Nv4ywpv5NNXF9i4e4Zb8pQ i+ItSC175ysvIAIaXHtgqdEu4zUgAXgM7VMsD3iOIYF1a/K6yrZv+FeNNknc81akjemmOef1bMlW u9vd9TcB6PI9XOx4XdNWesM56GlGYGwV/fThsmOzq/++1cXnfOZCdz5jO8clo4+VXsf8AxT/tii/ MGfeAAAAAElFTkSuQmCC when Bank Alpha undertakes Project I and data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAALAAAAAhCAIAAAD277bvAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABEBJREFUeF7tWj1a4zAQdfYsgWI/TmBOEGioaOlICQ3dlnQ0SUm6tFQ0kBOQ E/BREN8lK1m2NSNppJn8rPnWckOwpdHMm+eZJyWj7XZb5Csj0CLwK0OREYAIZEJkPiAEMiEyITIh MgdoBHKFyOzIFSJzIFeIzAEmArllMIEayrBMiKFkmhlnJgQTqKEMy4QYSqaZcWZCMIEayrBMiKFk mhlnJgQTqKEMOyAhqvn5aLrqG7jVdDQ6n1fQjZ/hWN/AMNffkRAa4yNkv5pPcS6ZUdhhq9dFcfvn biyeyJwQ4Btz5g8YxoJX/UBGeG1mZVHONmjW+y2K9/bdPkWP8Dxtyblcw42diBHoh+9axDEzMRRN 96B1DsZjphT4lhDCPYcL0IjCG7JTCH0L4FfjoxKp/yqYIFz1il2OzfoASR6yCSMgAD3SNR92rJ7U 4eGzsI2ppYxLAJJGQjjlw/loxIlL2RESwoG8w0unoSFEDXSTFvUJgm0qgk0ZmxAxIx2mrrXu/4Bj NRlap716Vz8Fa9bgOSWhL0okIHXrJVnJKDsiDVHNH1WHvpok2uHkeftsxqhPH6Cfj0/PduikTCPV 28u6nD3EnLOOac9aJ32XtBApzk47ITK5UoxYvCLBPL68Ltcvb0i97hCceAoTjaRdyo6EEBpynw8a mWJxMTp/+kp5UQOdJlTcDGFk9XS/xmpS4Bhesfr+VAXi94njx+c3yn5fjMBeHQRSZdLaEXQxp5DC mVae0GLLbxCmU5edsiQUJaMMkgU85RgUC+06/r3QKKNBQuE6QtbjNyNMZlbiPZcPL7CjNQQ3gAgh rPhydCPq8B4SMI9GYMTBovIeb+h2M+Onb19CHC653CxYriRlDBNeZEcgKlMSUD1vJH1QgaU3auH3 kBSNeGcb2QZGHDNK3Mmqfy+kKs2LdDhCMIsCKmOivW8YXjerAg1RS0Knkfrtfny3VBgjBbaantyf vdMarjVSL7D+2gQ1BG1ES92EmtQWA44RYiXshy8qKK2jD69il3OQmlJeoedcSOHcUFi+HQEhCMdV +P6BtUVPnWlefM42zbZDqZdph4eaibAhxJxaN2Kk0GqyvL70zyYTjkXycPJblQ3AaXfXAaaCvUh3 V+9gYhfceO3ChhgawF4S3rAdQaUK94yunJrKjAup1+bg9hefjZhO3xVBUKWTRsKVM+oYLSDtmVXT DqhOlmzhAmgFQ2NooNYWhTdwRGtSI9AQ5JmtI4fcEx33JSCfo35sYwuqLZAsuo3TjjWxOK4hYoHJ wRV64kMMDbM9sFHgsTgKyo6IEPROq9ll/GuJRW388AvXlC7BW8gY2hMfGJ7tN0SoISYPs3LxuOc3 krv0zdAc5sHpoZaDdqr5zX0xWx7vW9VjOM2zKefT//pusJFI7b/Zhn7iQGGFMPu3j+2yuDnG7yF4 HO5zlN5S3hTLyBchfXp3gLX/AjzYo6TnMS3OAAAAAElFTkSuQmCC when Bank Alpha undertakes Project II. Under the increased equity ratio of , the regulators’ expected payoff instead is data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAQ8AAAAhCAIAAABInLmbAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABqdJREFUeF7tWzt220oMpd5apBQ5XoG8AjtNKrfu5NJq0r3SXRqrjDq3qdJE XkG0Ah8XsfbCDGY4f2AGQ0q2kwM2kUlwANyLO19m1vd9J5cgIAgwEPiPYSMmgoAgAAiIWqQOBAEu AqIWLlJiJwiIWqQGBAEuAqIWLlJiJwiIWqQGBAEuAqIWLlJiJwiIWqQGBAEuAqIWLlJiJwiIWqQG BAEuAqIWLlJiJwiIWqQGBAEuAqIWLlJiJwiIWqQGBAEuAk1qebyZ2et8c+C6eCW7w+Z8Nrt5jLzB veTWK0WDuQH4eLjpXIarFD/RYgbFMXHgZ/GGUJ/IdZNaIIbl/Yv6LzH9r9t5HBFWrCeKOW8WnF93 D33/7eKoPg+bmyP2Chff+v6hu441jRbf/PYXgPxyvyym8/hj263+j5k4FRQuEDSLo6L+Zo3V6QZW uNdu5dQSvQKsDipKmiKfhIWw2mWtGcCSB30PAWQ3CR9gG1zha9GjIHCkOpG08BrODanc8/u6xSyv QS3IfQMX0j7msoAD2Y5/YBHkos4tpal2hfqJm6a4xjsjzyLOckvYqFqoonBh4nVk5WWi8mR4QWTe UK2gCtKNKr/wr2o6rEYdlgvJeLd/UlWb4R/VDvJWIfeGOo/iznhC0MhuFXDQ7Y3kqKKylpIaZWvT 8uMv3qWUuLZqoToj9W7OctcSLqYWtITtzTAt7yhpRudkIwubi5seKh8ZvLJu2dWve8fnrn6F8o3E ylNLJYJy7nShEUMFNubgTOfRl3BwvUw7RxYAcuLQUlMjbEv1EzVX4rqmFpTl5nVLulq5U1Pnz+lq Aea25BICZtvd2Qe37rn4rOSy/eHW58uPC+Nk8XHZPf02uwmHzfW6u/+SOjr8/L5H/GczXxXQEI/6 Fa65Xp73SqpZAvyp8+PX9X4ZBlbMfWh3/ulquf/+M9oowe6RYUDekVeFEAcKj0M3iSMdWFPEfERr lrX68e8fj+uB5WlqYTGUZH/4/aTmPlYR7qGVRdftn1/MXahkoyqjlYd0Z8GY5G0Bjd32cnb+9bkE PSyIL5/UrsX4vYHDRvUWy6tPyZZHjfBu/uHM51mQENEQkJcu7xEomDjkTqocmVewLKqpTzVgxpZW 3RSuHcvT1IIXayseMIbYC34P44ze8dG9PlYcRSewp6SG4f12u1eqyfdgzVb4Yq3Glex6unO7t9Xt XtNbJLtS7PR9B9FWfEBeMrAQPms4sEPV4zx+pVmAVXDU4HbCwx9VYPmBKUs6Nh8LzrV6zqDbswxq ed3cykAofncrNSyo63K72kGv/3hjf/ljiAFu3c8Ek7qwbZhpmFUJNBcrBp4NS8T9euEe6r64u1I7 0WZWq54VeQUVT5rGYWIdpp40THoWlg1nJBQlHJqKssHY4kstSrLzB932aeqQ4Fr5Y9IdsAxqGZeb erFUrA3Y6rWDr3kfDmgFOlKrmsX6TG8271b79TUchMBUwC1tcI/Dzhg2wqj3QZtKTnfDqQr0xZbJ +e2D0lq6ugidwODH6+MbwKiaEgNtDYoiDlWnespL9Uv1t3kWY+uQF1vKNciFQ3fI8qSZWI0hFCT9 klubWJN88aGfBIt7PzHrYF8ga4FmxNR9sI8QmhaGcTxS+/LYJYt3TgyKxdLiz8LyZoo4ROYtHGFZ nGaUMCG2xJZgUJ6yoQ3HLE9SC6/LSK10zEHtpnscgb3qR9HFvdstgx+5bhRZ+VrF6BEmc9HsKuiY 1GvRI2I9aeIz4/PYJQs0jXcQZQnpvRl8UwGBooBDhToeR2QWY0cJVkHxYqtwDQwy6E5Zbtnvzs5b agcU+F6+ORQbTj0IE3t2hh1bmvWIeYJG4E5w1FNwE8SdHIZG3rHDLOc/OhUy53r45wvhaQRlgp9U ZHez5PDz2cFjDkUBB0/7eI7e6rylVD8hTSWu9XzeV6Fd4iZnlSnLE08nKbmYQOMrisSdIpNFl1WG vxE9Io9HA+9RXQeulQkVVYikla43Lomlmjv2zcog/FiACbrV6syhiHONxVuNs8JRNZyWjrjVlooN 6dR8HaTn9jE6eeeXsTxRLcSnW6255/ZoOfrswrwLrA1jy/RwjtkCEW/1LL84sLg9PnQ4OwEOb6qV Y9LR0tZktRAdZUsM020p6k5QJRODLQ3GWecWGtcmveEEEGuoPG1szIobTGOz7968WS3DuBaB/y76 mffPIDl9y0IPJ0nkN8h0bZ0UivqK7d0X/egAZ+pN1k5EzUhtNunjkPFfkdQ8/JvP1c4MfH2Dn9f9 myn/vVn9AX1f/0uErh4jAAAAAElFTkSuQmCC when Bank Alpha undertakes Project I and data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAO8AAAAhCAIAAAC+8GsqAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABltJREFUeF7tWjt2GzsMHb21SClyvAJ5BVaaVG7dSaXVvC6lOzdWGXVuU6WJ tILMCnRcRNqLApAckiDBz3xkOXM4TZwZfi4uLkGA1OR8PlflKQyMgoH/RmFFMaIwgAwUNRcdjIeB oubx+LJYUtRcNDAeBoqax+PLYklRc9HAeBgoah6PL4slRc1FA+NhoKh5PL4slhQ1Fw2Mh4Gi5vH4 slhS1Fw0MB4GiprH48tiSVFz0cB4GGil5v1q0jy3m9MHI+G0uZ1MVnuCCt85r66IGunL403Yop4Y /sCIHhVD8pBvxftT3UrNCG/+coSfRJ9/P04pWE5M72YOTv5QvZ7P3+8GnfO0WQ24au++n8+v1QNd c6w4po+/keTjyzxqzv7ntlp+o564FBUaCGvFoKz3GAxZy312S61m0gVZVyrX77GtftyPrp+WO2s8 40PyGlvgoN5LbnbV1oJgdwthY9TjIQ9pzG8YwCVsp63FvJ5daibmvSSLGT/pCG6aEE7ipFzWc6U0 SDsPedVmWFbNDBlCLdphUjuGDqkZ83/63QjWm43VMqtwMQUAwH9hIlstFJvE0kANqYpyBCP4q496 Wy8XZjHk65Dg9vzEsOG9ivAgxovgbLqaPcIVdHAVtJFU17Y88t5q5iQG72w3UvnaNClbBDRJlj0c HVop0zGfFaB+qfsYBcaw5ak5gaBBzdipe3JCCIRaLmarBeF88tHHeNBM8zidUGJ5yJh/LTmHGW6d N7vZ8hOkbl+dbBVSKzuvnn66SadC888z1Uj/Nfs8rw5/ZLV52jysq5f/3bT49OtH7c/vzwaIVErt YDu+1bCQXAPScHWL/fO6ntvAMK9Mpe/TL/fz+scvUkhz74I40G4yKzCUQ4XhoYrixIy8uvmka6O7 rxBwtj9pjd0KcQtKU03DyPupOYvBSlCjFTN9/Las6vWDLq/2qwUpZuq3o7QHlSYZlVp+dStP2cSs g4YGpLnaLia3z28xZrBgWhygqk2JLzzIaQOreX7/xSmJU/6ocIFrO1XrFuLAJeSWfwwVmTz4aE9/ DpB/6fjSNGhCi+aZsSJp+iUb9FMzLyYufO8sxeDa2t2sZ+oIalFBjtF8xnisYoCo2EXU5JwXJQXP BGA/qrfbGlTtn3HJo8bZGuKy9xye9OlY8jhNrmbnVCHbXV3FgUvICcyBOVM8ZEOt0C/841qBrayj XH3SaP+RJDYfGGmJar7k3DKqHkn00zFRleaHhTmHBf53Swir8Cy2S7EGMHbLv8wxrKJDxBBrQ7RN wzUjM3Ycjioav6nypoZV1XwUsay6h5M+mZnCtyjvuMp6pSncYlKpVWQ/wCzD2w6CVMR46CiaZLeG 31CN553vihH76xDV3G1u6BgTE8ID9c3WNzuKHfUNOZ9OG6aPr6C5ev3cJGUGjlTwk1Y1DiZLRZWp iIycCw6Gb3WywUXoqhJrB+T+pNIejGUNWoXLyW5tR+LmkRcjk+5v0SCwUaWoiPKQnl7UF4G4ke6d 16KzDvXwvTKNOIP7lVCfm5T6vESqRKv4M4lHhTWJm3VGCJO6dGsY1SG8hYrkNjxP15TZAO0ijvws wyckygNpzlvuJ9LYibOif5TN07/bqpeaI1NCWMYCS0t5v2r2bCEfEk8DNQfuPc988adPO/APX9dA pp8rS19gskKyB2txQTfyKYxLQuuRMuPQ+eIwPIsTFL7oZKiI8JBQi3CStf7dMw7ZPWhF/yh7DTXz YmLOIAQb8hHJKTnTQF1wLhIJc7DEEjFBVu3OyRHOQjILRwNWViMDrDlgs3CJjMiUeCLcmDXSL8sQ B2xs6stLvOGOu8omvHpUxHiIbmdw8KQzMJcl1ZG3opsOB+rV5jLGvwvk7xvIzXGDk1yLxe+99T0V uX6it4T6E3tD6CAIz01vIGg3vxeZlL/n42++6T0af+3gv3XYTd5W+FTEeJAlMn08wtVnztYknDbS atU2iPwid4GtoPGN/YVjX8QSDUZYhU8hzQ2AseMQAbzJu0D+Yp+ACFFxAR6up+UI7b3VzP34paOb u3d7Ry92B9mc+wV/YMT/NkuFy9xbd5aKodWcC6YnWa27t1Yzt/V8iHX6URk2LmH3G3W0TSVub6XB 39CFfX1RKoJWtNbe8B0mMOQgGbg6W+5xSzwIjH9uEKgu8fCHv0/456y5MuC/Rp1ffR/9faAAAAAA SUVORK5CYIJ= when Bank Alpha undertakes Project II.

The matrix depicted in Figure 5 below illustrates the payoffs of Bank Alpha’s shareholders and the regulators for the combination of possible actions that they can play:

Fig. 5 Matrix of Payoffs

The matrix shows that the only equilibrium of the “game” between the regulators and Bank Alpha’s shareholders is the strategy profile Project II; Additional Capital. 246In game theory, a dominant strategy is a strategy that each player plays independently from what the other is doing. See generally John F. Nash, Jr., Equilibrium Points in N-Person Games, 36 Proc. Nat’l Acad. Sci. U.S. Am. 48, 48–49 (1950). What matters the most, under the rules of the game (i.e., the existing regulation), is that the selection of Project II; Additional Capital is an equilibrium in dominant strategy. This means that whatever the strategy (i.e., the course of action) of the regulators, Bank Alpha’s shareholders are always better off by selecting Project II. 247Indeed, even with the higher capital requirement, Project II is still more profitable for the shareholders. Formally, by switching to Project II, the shareholders gain data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAALAAAAAQCAIAAAA5yWLnAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA+1JREFUaEPtWD124jAQlvcsDoUfJzAnWNJQ0aazS2i2S0lHA2XoaFOlWXyC 5AQ8F7Hvws7o/w9LMtm8t29Rg42lme8bzZ+UXS4Xch93CwgL/Lib4m4B3QIBh2jqLKsbWCAf1OJ+ P8tm+/6b7OkB8BWavQSRGR2U+l8Y32s6LwHLnviKY0agZAyMU1XuOvwuH9jkblcS/oV+pDrZH/gJ R3UaFu35yuXoK5k0CUJTmiyd0eDWEeC9BEGpIqctuwosBYvXdBaqFHnOXFOBxlk4huQG1jB44vuw Q4BsZgT5INzBNJiJAd9GuANVU1WVthmGO3AcpuYU06E3SDrsyU/QcYgwsFgcjmjNWJTteHocAvV5 Q4qxH2BiFuKenUSHGC4ZXTtd/ETHkg/40v9+JcvHXMtEXftRqn/grWLLUkfXkqJQi5ptu4Rg1XTl j0uy3o5K5P1+c6hOLwJXWTzovAyCLuwgsEimrulw9ygUQvLVcVd+tF2krCuVYFN0p8qWIlSgkpeV 2jrXntwhZAmBngCeWe1EE54/oUmQDxQDkPqYTnR/6D/PRP3TvB2U/iRy/ScpHidTzqapN8WCWLqA QUkxJQ/lpk39sJ4+g1muEHRFRwCLwuMxnWPMceyYeiBEkJgxlNKmdpoix57oEOAB8zOr/8t2W28I j6N89X55R/Hywc8aNZLDnHUlWTY/6DEdZShOBzLPJH8o6I73+7fiuCKQenj8KEGjgoi5KW0X3xaX C80UCQSjgCVwFVPdbGrGWorIfv/UPvMUqLkVqOC7Mz87tkT5hj3BIdBUuyP3q/OBCJnRWLBgqLoE hcjhJBKQ8Bn+a51RtLTdAbfFKkdoZnHygIoSDkkMJaELnMg88XAUBSwKhg3fzKYYWbb/x4tttq/L X7QiQkwpRXR7+cEgxtmw8Rbb6TZTvl7J7hnNXhXexjWU8iBDuyLR8jnC4jA6uDVY4Z7X0iFOIsPA YtpKW7WpSDW9MbKsObrddTUhtjoEq6ls6qdXVoj2g12bVXa+qoEAT2YODP5d7tDVfQHjVuGoRKZF YrNde8rQgJQ4YFEw7IoNuVUELdZtvemNkicnYfOgGuZ8MiWiZug1CQqm3US49lTnVAhK98ji9VXN 68TBnmUF40Iiyc3dKwjvfcbI/IDL4DzL7RfMYFbU4DJtzQ0XLeyWhssScmJRXbenJYkKpFnf+WAf ap0UFbiHuIohlIiSnCF68kh3cK7VQgpH6wkJ5lcpY4tqjPiUOTbP8MXUoHQM6puvUaLx36JNXj9F apOBFcwlkQLtabeQGakyAEFk+jKDiWnl6t+bDaXziRzpAfo+Qhb4HxwiZIP7d80CfwCpMChY8GOg VwAAAABJRU5ErkJggk== , which is positive since data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAJkAAAAQCAIAAACKgUr9AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAudJREFUWEfdWD124jAQFnsW2ILHCZwTsNtQpd3OlGyTLiUHMCXp0qaiwT5B OEEeRey7OBr9jiTHHstmn1kVPD80+mb0zYxmJFbfyWBogMl5mubS9DJL1GeeJlkp/9TTeYrWyVkh z3+YEW6ioAnfQZ4ebz8wR1P+xtSBnYsl+6yEweV1tVnDR3H6ePw9F/9Vn2y5gI/1UXg2E15838Fs eeVz8917vno7S4SmEeIXhwMXN8gTJGt64UW1SGYOJJgaOlFx0qoslb7UaQwJabP5O30+vkhjm65U M/+dHFPnBo6y1rOHZJp/gjknHaiKUKGdhpZy2BAI5KxXA3PBh1nXAatWefgdyCRmeDCMRrWCMhRI X4roVgQIziK4RlsRShwIh4YyS22a0BiwUqgm9l2qwnbY3qKU4kUjUu2ljK2XiSwwbL57zZLLtYyu B8V2vyzz1IfQ+KDhKApX31EdHmaz00ZWvdixPg5bH6vXycY2qovt7AEKM20kukPg4tKX1fntsvqJ KfpQjQUNEUlVhz179tm2+MV2W/iY3PqmEeyI9yt1vTnNQoTeVo69gLoFAtW8W3tlfwQhHT4NvKbr JSoxA+qC6SjcUoOKRPQJZzBaiuHgA/D2AHwbZKp1i/DNjl2ouhb10iW+6eoVNC8ysH3H2GLGQeyk xY9vA8fOpKF4kV7vproBGNgPcyDo/MCXDu+i0YoLfRwnOLe78pwYKHT2uu8bdCyaJHULPalWidno DgwlNwy+RD4QNsV50iMQRY3n4zh4GqfmvnlbJVRjAjki1To02gqSCwX7ZeiuDcdOLAcejD2Bg4no gkknsF9emvgdEMgk22hUk85Fn1VBqrpfkmy5G6F+vjTS/ZZNj427eY8l9yr8Frr4e3n51X51EZcI 2fOL91mANx9kXRMTnF543cAi9baukXUCiq7a1B2/xR/djhbPj6Lr/8vL7lypztfHpzWD96mnxWH/ wuBhhL9xyI/bjRaHjaL0C33MjllnmMTOAAAAAElFTkSuQmCC . And, similarly, whatever the strategy (i.e., the course of action) of Bank Alpha’s shareholders, the regulators are always better off by selecting Additional Capital. 248This is trivially given by the fact that data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAC4AAAAQCAIAAADmq9q9AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAASpJREFUSEvNlMsRgjAQhom1qAeHCqACblQBFdgHHLUET1yEDqzA4SDpJW6e Ex4JCwMz7IWQx7/fbn4gjLHgGHE6BganmEdpckLyZg9ioywH8yhBEBX3ZA8US5mnGKIAYL8F9PcN r+cNSNzKKsUApameWdprQdeG/QkHFS1jEpfUyexR1inqTJzOaviUGLyIATyjooNBV0RqxJcnQwnI /XYglU2KwCaAWaloUJwAYo9VhJtT1IZR5ii6F2Y/Pynb5OmEd4M6t0gZvAKuiW4XqLBrP9Kh9P3y GyR5MJZWhIfvO1+oLDvNS1QlIOwx4QhltrFb8MraK5bzMZ0fXxwvyGldpe5XFigi9L16LLJyCals /ivmXjf4m/UlsMoGxXh2cxSsMoGmb558neAfUG/yMxH5UbIAAAAASUVORK5CYIJ= . But the strategy profile Project II; Additional Capital also is the most inefficient outcome of the game, being the one that yields the lowest aggregate payoff, i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACoAAAAhCAIAAAAgZq7PAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAcBJREFUWEftVz12gzAMNj1LyMDLCcgJyNQbdIMxOQqMYesNMsEJmhPwMgTu QiTbMvIPr0Nf66F44dkS+qxPnxSSzPMs4q23eNCIvMFH5H8jfyM/EgOb9CIRvw1dLr2pOSZV/6el iKx8AZ8buLrSyrrs9Dk+xjo3RsvAfPwgeT3adh4G4slICC/PwRufcCi3BoaMyz3CN5D3N5Aqm8VT QS97sgO8gdPwkgryRD+Wh3wtiA8Wnq+Nx3PgdJfB2hfX+VpIvvtbK8RhvyPyi3fAb28BfcI7X2fj J3b7w/cazjNDPiRZlpJ8t+pWEW2O3eIve5cm5z0y+9LjF/BJC9AYuIMtH3Lg8tYoRD5wpxXenpIf dv/UfFxEPer6qRrgTDkN1AxjPQDKsZkoey1srX+Sl5/ruvZ0jsHEV1gUAentzp/QJUpeUkD3x2ir KM/SNVn1VXo5dCRc4zU+7paCdWT5nd9XAbI1RJpBvzKlu51gXQMIRn4N6X2F9OKSYYan2qhiPAcQ Oyrf8AkUocrtVueSdTi0C4FGt0nMXo2BxUxRZe2dieuOS2b2m5DPJ68kvju5aIsvvfVe/gVL5F+8 5F//wX4BQExiXzxQtykAAAAASUVORK5CYIJ= . Instead, the efficient outcome would be the strategy profile Project I; Status – quo Capital, which yields an aggregate payoff of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACAAAAAhCAIAAAA3RD4GAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAWJJREFUSEvtVruRwjAQla8WQ+ChAlEBkJNeJsKjDxIIIaODi+wOXAFDgN2L b3f1s2RhjQLPHDNWYn1W7+3nee2s6zo25fiaEhyxZ4JohucUzSmKZiBqMKvof6WovayzQxX1Kc1g 8iIz+ODgKIXjmCjVvnk0Z874ufG3nTXa9AaBIAHtw2V8wiYt+wyGfIxAgttr8pIogcAAKgIKR1ui Hc61E+8iCJwThQjWYHPtrhsZK0zNPK26ZM0LkyJYCEEpCo5YBKqKNonS/5Jq4BY5TBEn8KWicDQB HlsRhEU0riLXBYkFAXkESkuuigz5iIqGESpZDYuc/9yB/fab9ko3z5qx1TK3QsiXK/VfVB0CDYIX iyTRLApIyePV2kvt64EqkhHctr0eVJ2ONd/ves68oQLPMu1bvttzVh+/L5oCURjAUA28PuGk2nv9 iUtpQCvR6NrBUSjDIo92m/TDybtp9vG/73/m9pcH5d7+XgAAAABJRU5ErkJggk== . This strategy also yields higher payoff for both Bank Alpha’s shareholders and the regulators relative to the payoff each of them obtains under Project II; Additional Capital. 249It is important to emphasize that while the strategy profile Project II; Status – quo Capital also yields an aggregate payoff of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABcAAAAQCAIAAAByTXNPAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAASFJREFUOE/NkzGSgzAMRWXOglMwnMA5wSbNVrTp7BIOkDJdGralS0uVJvgE 4QTMFjF3YWXLeMxMNptJmlXlsfQ/1pNg0zTB25G87WANgotWSr/uiB1NnQx6URt748MmZBddhKOp xaxBCb5Fqw106ITlpob2Mtr0+LVmjB2GULt4p1a8yskdJRVPYLwNIuNUlJbXa5n6E5acirtNogTk 5wdJtoVALmm5zyvONs3zVNJVDs2ZMI6XtpfgO6U+l1Tsc8UvXFzKheU2zwjtZWeKlj81Ka3YDk7E JTuw9WJfbI/DzdF9GPrciGLr+DkufYIjYuH75rvPV5S9E1hJpTwTfXX064UaQC7R6CMI8a1fmnh7 lis206V9eTXYf/wb/5rLw/wPBjcZKnzAUMYAAAAASUVORK5CYIJ= , the strategy Project I; Status – quo Capital is more efficient under the assumption that the shadow cost of public funds is non-zero (i.e., not negligible). See supra note 246. Under this assumption, since the regulators’ expected bailout costs are higher for Project II, the outcome Project II; Status – quo Capital is strictly dominated by the outcome Project I; Status – quo Capital. Thus, the equilibrium of the game shows that there is room for Coasean bargaining, as long as two conditions are satisfied. The first is that the shareholders commit to the undertaking of Project I by using a credible signal. The second is that regulators reward this commitment through the exclusion of the additional capital requirement. This simple illustration shows that the use of safe governance arrangements, such as an advocacy system, would be a rational choice for bank shareholders, if this choice were rewarded with lower regulatory costs, such as lower capital requirements. Under this regulatory scheme, given a risk level acceptable to the regulators, bank shareholders would be able to make optimal trade-offs on two margins: the cost of advocacy and the cost of capital requirements. This means that Bank Alpha’s shareholders would optimize their regulatory cost of capital by choosing, for example, an advocacy model over a CEO-centric model.

Under the current regulatory framework, however, there are only superficial references to banks’ governance arrangements. The only extant provisions on regulating bank governance come from examination ratings, such as the CAMELS ratings used for depository institutions. 250CAMELS stands for Capital adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity to market risk. The CAMELS rating system provides for both the assessment of individual component ratings and a composite rating. Each of these assessments yields a score that can range between 1 (indicating the least degree of supervisory concern) and 5 (indicating the maximum degree of supervisory concern). See Fed. Deposit Ins. Corp., Risk Management Manual of Examination Policies § 1.1 (2012) [hereinafter FDIC Evaluation Policies], available at http://www.fdic.gov/regulations/safety/manual/section1-1.pdf. A similar system—the RFI/C/(D) ratings (Risk-management, Financial condition, Impact, Capital, and Depositary Institutions)—is used for bank holding companies. See Div. of Banking Supervision & Regulation, Bd. of Governors of the Fed. Reserve Sys., Bank Holding Company Supervision Manual (2005), available at http://www.federalreserve.gov/boarddocs/supmanual/bhc/bhc.pdf. These criteria, however, are more oriented to assess bureaucratic features than real authority in corporate decision making. 251For example, the evaluation of a bank’s risk management system is based on very detailed provisions in the examination ratings. But even detailed risk management regulation is virtually useless when the overall organizational structure is subordinated to a CEO with a large appetite for risk. Unfortunately, existing examination rules fail to adequately tackle fundamental issues of control, such as board composition, expertise, or independence; instead, these rules are vague and only employ loose definitions, referring to indefinite attributes, such as “ability,” “adequacy,” “accuracy,” “[r]esponsiveness,” “[r]easonableness,” and “willingness.” See FDIC Evaluation Policies, supra note 254, § 4.1. Thus, because of the manner in which they are formulated, governance requirements only provide general guidelines, which have little, if any, binding force. More fundamentally, governance provisions play almost no role in the regulators’ evaluation of a bank’s appetite for risk. While in principle governance ratings are incorporated in the Federal Deposit Insurance Corporation’s (FDIC) determination of deposit insurance premiums, 252The FDIC’s “risk-based assessment system” classifies banks into three capital groups and three supervisory groups, which incorporate the CAMELS ratings. See 12 U.S.C. § 1817(b)(1)(A), (C) (2006); 12 C.F.R. §§ 327.9–.10 (2012). An excellent description of the FDIC risk-based assessment system can be found in Risk-Based Assessment System, Fed. Deposit Ins. Corp., http://www.fdic.gov/deposit/insurance/risk/2007_01/fr_risk.html (last updated July 7, 2007). in practice these ratings constitute a minimal part of a broad evaluation that is predominantly devoted to assessing a bank’s capitalization. 253It is worth observing that in the case of capital requirements, a theoretical exchange between safe governance arrangements and lower capital ratios is provided in the prompt corrective action system introduced by the 1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA). Federal Deposit Insurance Corporation Improvement Act of 1991, Pub. L. No. 102-242, 105 Stat. 2236. This system classifies banking institutions in five capital-based categories, ranging from well-capitalized to critically undercapitalized. As a bank’s capital rating declines, prompt corrective action rules impose progressively stricter regulatory requirements. These rules also provide that a bank can be treated as if it belonged to the next lower capital category if it has received an unsatisfactory rating under the CAMELS system and has taken no corrective action. See 12 C.F.R. § 325.103 (2012). In practice, however, the largely residual scope of application of this rule, combined with the bureaucratic nature of the CAMELS governance provisions, makes it highly unlikely that this principle can have real teeth. In fact, when one considers the broader context of the prompt corrective action system, it becomes apparent that within this system bank governance only matters when a bank’s capital level falls to extremely low levels.

Thus, in contrast to what uninsured debtholders would do, bank regulators fail to bargain for many “contractual features” that would include not just capital requirements but also governance arrangements. As a result, prudential regulation is currently unsuitable for restoring bank shareholders’ incentives to select more socially responsible governance structures. To remedy this inefficiency, this Article suggests that bank shareholders should be allowed to trade safe governance arrangements for lower regulatory costs, including lower capital requirements and deposit insurance premiums. 254Under the same logic, banks adopting safe governance arrangements could be subject to less stringent activity restrictions. Since these restrictions impose opportunity costs on banks, they are a subset of regulatory costs. See John et al., supra note 9, at 96 (jointly considering activity restrictions and capital requirements as suboptimal and costly means to discipline banks). The discussion that follows attempts to devise potential measures to implement this change and addresses the possible objections.

C. Incentivizing Advocacy in Banks

In an ideal world, this Article’s proposal would inherently lead banks’ governance models to converge toward safe governance arrangements. And there is a sound argument for claiming that such arrangements would be built around an advocacy model. Assuming that regulators could hand-tailor negotiations with banks and appropriately price the risk incentives in banks’ governance arrangements, shareholders would rationally seek the implementation of such a model. In reality, however, regulators stand at a greater informational disadvantage vis-à-vis banks than debtholders in private contracting. Debtholders only need to monitor a limited number of borrowers and generally enjoy vast economic resources to accomplish this task. In contrast, regulators are called to supervise the banking system as a whole and may face severe budget constraints. Thus, imagining a regulatory system that perfectly mimics the operating methods of private contracting raises feasibility concerns. Monitoring the risk propensity of governance arrangements at thousands of U.S. banks would make this system so costly as to be potentially unmanageable. One would have to be willing to accept a high risk that banks’ governance arrangements might be “mispriced” by regulators.

Thus, while this Article’s analysis applies without distinction to all kinds of banks, the need to address the above implementation issues suggests that the adoption of two different regulatory regimes would be desirable. As explained below, regulators should resort to one-on-one negotiations only in the case of “large, interconnected bank holding companies”—as defined in sections 115 and 116 of the Dodd-Frank Act (i.e., bank holding companies “with total consolidated assets” of $50 billion). 255 See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 115–16, 124 Stat. 1376, 1403–06 (2010) (codified in 12 U.S.C. §§ 5325, 5326 (2006 & Supp. IV 2010)). The remaining banks not falling within the Dodd-Frank Act’s categorization (i.e., non-systemic banks) should instead be subject to a standardized system.

1. The Standardized System: Small and Medium-Sized Banks

The theoretical background offered by contract theory assists in better understanding what the standardized system this Article proposes for regulating governance issues in non-systemic banks would entail. 256 See supra note 24 and accompanying text. Contract theory suggests that in contexts of asymmetric information, a way for the principal to elicit private information from the agent is offering the agent a menu of contractual choices—a collection of payoff-relevant alternatives—to choose from. 257An example is offering a menu of contracts where each contract specifies a given price and quality label. The underlying intuition is that adding another contractual dimension to the negotiation between principal and agent (i.e., the quality label besides price) enables the principal to infer more information about the agent’s type. Economically, the adoption of this strategy implies a model of screening, rather than signaling. The seminal contribution in this field is Michael Rothschild & Joseph Stiglitz, Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information, 90 Q.J. Econ. 629, 643 (1976), which studied screening in the insurance market. A model of screening—where the principal rather than the agent takes action—better characterizes the nature of the regulators’ intervention. Nevertheless, screening is equivalent to signaling: both strategies aim at achieving a separating equilibrium. As long as this mechanism is well-designed, the agent’s choice of a given contract within the menu reveals her private information to the principal. 258 See id. at 629, 639–40. Explained simply, this process sorts good types from bad types.

Applied to judging governance at banks, a similar mechanism could be implemented through regulation that “offers” banks a menu of standardized regulatory contracts. Under these contracts, a fixed set of regulatory costs would correspond to some predefined combinations of organizational features. By opting for a given mix of organizational features, banks would reveal information about their risk appetite to regulators, basically assessing the quality of their own governance arrangements. In pragmatic terms, the implementation of this system would require regulators to devise a framework of proxies for evaluating bank governance: i.e., governance metrics. Based on these proxies, regulators could identify more and less risky combinations of organizational features and assign a corresponding set of regulatory costs.

For feasibility issues, this Article suggests that the regulatory menu should include just two “contracts.” 259This Article opts for a two-governance system instead of a large number of regulatory contracts because benefits from having multiple contracts are uncertain. At first glance, an increase in available regulatory contracts could seem to add to the precision of the system by synthetically replicating an assessment method based on individual negotiations with banks. But, in fact, this system can never ensure that the self-interest choice of bank shareholders for a given combination of governance features and regulatory costs is socially optimal—as it happens, instead, under an ideal system of one-on-one negotiations with banks. At the margin, enlarging the set of available contracts may increase, rather than decrease, the risk of mispricing. And even assuming that providing for more regulatory contracts could add some precision to the system, designing such a system would bring about enormous implementation costs and, therefore, raise feasibility issues. These contracts would limit banks’ alternatives to either an advocacy model or a CEO-centric model, with the distinction between these two options being based on a restricted, and readily observable, set of governance metrics. The first contract (i.e., the “advocacy contract”) would offer banks a fixed set of regulatory costs and an advocacy-based governance model. As for the set of costs, for example, it could be established that banks opting for the advocacy contract would be held to the standard 8% capital ratio that current capital adequacy rules require for adequately capitalized banks. 260 See supra notes 22, 229. As for the governance component, this contract would select a combination of organizational features that integrates the minimum requirements any advocacy model should provide for. As discussed above, two features could form the baseline. 261 See supra Part II.C.2. The first is a board composed only of independent directors. The second is the provision that the compensation of the chief risk officer (CRO) cannot be tied to stock performance or any other equity-based measure. Moreover, there are additional organizational features that this stage of the analysis suggests should be included among the minimum requirements for implementing an advocacy model. For example, a substantial portion of board members should be financial experts; 262Some empirical studies show a positive correlation between the financial expertise of board members and volatility. See Bernardette A. Minton et al., Board Composition, Risk Taking and Value: Evidence from Financial Firms 2–3 (Aug. 16, 2009) (unpublished manuscript), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1455997. But this evidence does not show causation. In a CEO-centric governance model, the expert decides on the basis of the restricted, and biased, evidence provided by the CEO. Instead, in an advocacy model, experts are likely to add to the information aggregation process because they would be better able to assess the conflicting risk information produced by the CEO and the CRO. the CRO should be granted access to specified budget and staff; the CRO should only report to the board; and, finally, the CRO should be removable from her position only by the board and with cause. 263These requirements are largely in accordance with the Basel Committee’s recommendations on improving bank governance. See Basel Principles for Governance, supra note 20, at 18–19 (Principles 6.72, 6.74, 6.78, and 6.79). This combination of features would counteract a bias toward increased risk taking by implementing a system where the CRO has both the incentives and the resources to effectively exercise her risk control functions, acting as counterweight to risk-loving CEOs. That is, this system would enable the CRO to effectively provide the first line of reporting on risk choices, preventing risk management from becoming some cosmetic regulatory compliance, as it has often been at many banks in the years prior to the crisis. 264 See Rajan, supra note 1, at 140 (observing that “risk management was used primarily for regulatory compliance rather than as an instrument of management control”). It would also prevent CEOs from repressing conservative risk managers who disagreed with them, as also happened at several prominent banks. 265 See FCIC Final Report, supra note 93, at 18–19 (reporting that repressing non-complacent risk managers was a regular practice at major banks, including Lehman Brothers, Citigroup, and Bear Stearns).

The second contract to be included in the regulatory menu offered to banks (i.e., the “CEO-centric contract”) would provide for a pair of terms that includes a set of fixed, but higher, regulatory costs and a CEO-centric governance model. The regulatory costs could, for example, be set to the 10% capital ratio that current capital adequacy rules require for well-capitalized banks. 266 See supra notes 23, 229. As for governance provisions, this contract would include any governance structure that does not implement the advocacy model described above. 267The current corporate governance structure of Bank of America, where the CRO is compensated through large stock option plans and reports to the CEO, offers a stylized example of a bank that would be deemed to have chosen a CEO-centric model pursuant to the regulatory reform envisioned by this Article. See Jeff Green, Chief Risk Officer Rises to $10 Million Job Following Derivatives Meltdown, Bloomberg (July 11, 2011, 2:18 PM), http://www.bloomberg.com/news/2011-07-11/risk-officer-rises-to-10-million-job-after-derivatives-meltdown.html (reporting similar organizational features at major U.S. banks, including Bank of America). Therefore, under this Article’s proposal, Bank of America would be held to the higher set of regulatory costs.

2. The Tailored System: Systemic Banks

Despite the positive features of the standardized system, large, interconnected bank holding companies (as defined in the Dodd-Frank Act) should be subject to a different regulatory regime. Under this regime, the trade-off between advocacy and lower regulatory costs should be based on individual negotiations between banks and regulators. Two reasons underlie the need for differentiated regimes based on size. First and foremost, a standardized system can never eliminate the likelihood of misalignment between optimal private sorting and optimal social sorting. Under this system, there is always the risk that a bank can choose an advocacy model to lower its capital requirements, even when higher capital requirements would be socially desirable. That is, a standardized system can reduce, but not eliminate, the risk of “mispricing” a bank’s governance arrangements. In the case of large, interconnected banks, this risk is likely to increase and have more severe consequences due to the complexity of these banks’ asset pools and their systemic importance. Second, the relatively small number of large, interconnected banks (about thirty today) 268 See Top 50 Holding Companies, Nat’l Info. Center, http://www.ffiec.gov/nicpubweb/nicweb/top50form.aspx (last visited Oct. 14, 2012). would make an assessment system based on individual negotiations feasible, whereas the high number of small and medium-sized banks would make it impossible. 269It is worth observing that the proposed adoption of a different regulatory regime for small and medium-sized banks, on the one hand, and systemic banks, on the other, would replicate the practice of private debt contracting. Banks routinely use standardized contracts when lending to small businesses or households. In contrast, lending to corporate clients involves detailed, lengthy, and sophisticated negotiations.

Practically, an individualized assessment system of the trade-off between advocacy and lower regulatory costs would involve the following steps. First, consistent with the new provisions introduced by the Dodd-Frank Act for systemic banks, capital requirements for these banks should be determined ad hoc 270 See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 115(c), 124 Stat. 1376, 1404–05 (2010) (codified at 12 U.S.C. § 5325 (2006 & Supp. IV 2010)). through individual stress tests that simulate breaking-point future scenarios. 271Bank regulators have already performed similar tests. After the crisis, the Federal Reserve, the Office of the Comptroller of the Currency, and the FDIC jointly launched the Supervisory Capital Assessment Program. The program was tailored to estimate the losses and liquidity needs of nineteen U.S. bank holding companies with assets exceeding $100 billion. The test found that ten out of the nineteen banks under examination would have required an additional capital buffer to remain solvent. See Bd. of Governors of the Fed. Reserve Sys., The Supervisory Capital Assessment Program: Overview of Results 19–37 (2009), available at http://www.federalreserve.gov/bankinforeg/bcreg20090507a1.pdf. For some banks the required additional buffer was significant. For example, as regards the level of Tier 1 capital (i.e., common stock and disclosed reserves), Bank of America would have required a 19.6% increase. See id. at 21. The 19.6% increase is obtained by dividing the SCAP buffer of Bank of America, i.e., 33.9%, by the bank’s Tier 1 capital as of December 31, 2008, i.e., $173.2 billion. A similar approach should be applied to evaluate these banks’ risk-based insurance premiums. Second, the set of organizational features implementing advocacy should be determined on a case-by-case basis. 272To this end, regulators should also privilege on-site examinations and resident examiners over off-site monitoring through certified reports. See FDIC Evaluation Policies, supra note 254, § 1.1. This means that the relative impact factor of a large bank’s organizational features on that bank’s risk appetite should be evaluated by taking into consideration a wide range of control variables, including its “capital structure, riskiness, complexity, financial activities (including the financial activities of [its] subsidiaries), size, and any other [appropriate] risk-related factors.” 273 See Dodd-Frank Wall Street Reform and Consumer Protection Act § 115(a)(2)(A). Additionally, it would be desirable for regulators to include in their “checklist” of relevant organizational features, for example, the relative power of the CRO, as measured by her share of the total pay given to all the bank’s top executives, and the size of the CRO’s budget and staff. 274Recent empirical studies confirm that the relative power of risk managers vis-à-vis top executives, as measured through risk managers’ relative compensation, is among the most important determinants of banks’ risk management policies. This argument is supported by the fact that banks in which risk managers enjoyed more relative power invested less in risky assets before the crisis and performed better during the crisis. See Ellul & Yerramilli, supra note 203 (manuscript at 16) (finding that the presence of a risk manager with high relative power is negatively correlated with increased risk taking before the crisis and positively correlated with better performance during the crisis); Keys et al., supra note 82, at 702 (finding that relative power of risk managers has negative correlation with loan default rates). Finally, the measure of the trade-off between advocacy and lower regulatory costs should also be evaluated ad hoc, taking into consideration idiosyncratic features and the impact of this trade-off on a bank’s risk appetite. Most importantly, as private lenders do when negotiating with their debtors, regulators could ask for changes in a bank’s organizational features. For example, when a bank is highly systemic, regulators could even demand the presence of a public supervisor on the bank’s board for making the trade-off between governance and lower regulatory costs available to that bank. 275It is worth emphasizing that bank regulators have already taken similar initiatives under the Troubled Asset Relief Program (TARP). Notably, the TARP, which enabled the U.S. Department of Treasury to purchase toxic assets from troubled financial institutions, was a central part of the government’s effort to contain the systemic effect of the crisis. About TARP, U.S. Department Treasury, http://www.treasury.gov/initiatives/financial-stability/about-tarp/Pages/what-did-tarp-do.aspx (last updated July 13, 2012). In particular, under the Capital Purchase Program (CPP), which was the first and largest initiative conducted within the general framework of the TARP, the Treasury purchased about $205 billion in senior preferred stock (Preferred) from troubled U.S. banks. See Capital Purchase Program, U.S. Department Treasury, http://www.treasury.gov/initiatives/financial-stability/TARP-Programs/bank-investment-programs/cap/Pages/overview.aspx (last updated Dec. 10, 2012). In a little-noticed part, the Treasury’s term sheet provided that “[i]f dividends on the Preferred are not paid in full for six dividend periods, whether or not consecutive, the Preferred will have the right to elect 2 directors.” See U.S. Dep’t of Treasury, TARP Capital Purchase Program: Preferred Securities, available at http://www.treasury.gov/press-center/press-releases/Documents/term%20sheet%20%20private%20c%20corporations.pdf (last visited Dec. 23, 2012). Even less noticed was the fact that the Treasury did exercise its rights to elect board members under the CPP. In July 2011, the Treasury announced that it had, for the first time, elected directors to the boards of two recipients of CPP funds that had breached the six-missed-dividend waiver: First Banks, Inc. and Royal Bancshares of Pennsylvania, Inc. Press Release, U.S. Dep’t of the Treasury, Treasury Elects Directors to CCP Banks’ Boards of Directors (July 19, 2011), available at www.treasury.gov/press-center/press-releases/Pages/tg1249.aspx. By October 2012, the Treasury had elected twenty-four board members to a total of fourteen CPP institutions. U.S. Dep’t of the Treasury, Troubled Asset Relief Program (TARP): Monthly Report to Congress–October 2012, at 9 (2012), available at http://www.treasury.gov/initiatives/financial-stability/reports/Documents/October%202012%20Monthly%20Report.pdf.

3. Objections

This Article’s proposal is that making banks’ regulatory costs sensitive to banks’ organizational features would incentivize bank shareholders to adopt safe governance arrangements, adding to both the stability of individual banks and the banking system as whole. However, the question of how this proposal should be implemented is complex and open-ended. What is the optimal set of organizational features that regulators should focus on? How often should regulators evaluate a bank’s governance arrangements to avoid the risk of ex post shifts toward riskier governance models? These are only two of the additional questions that need to be addressed. It is important to emphasize, however, that experience would help to answer these questions. Especially in the case of large banks, the experience gained with one bank would provide information on the best course of regulatory action to undertake with other banks. Based on this experience, regulators could continue to impose governance measures that have proven successful to constrain risk and jettison those that have not. 276It is worth observing that shareholders, through the services offered by corporate governance rating agencies, already use corporate governance metrics to evaluate the soundness of potential investments. See Paul Rose, The Corporate Governance Industry, 32 J. Corp. L. 887, 917 (2007). While regulatory governance metrics should be tailored to measure stability rather than profitability, the experience of the corporate governance industry could serve as support to the regulatory identification of key governance features. Over time, regulators would also gain insights that would assist them in “pricing” the regulatory contracts offered to banks. And this, in turn, would enable them to better calibrate enforcement strategies, allowing for a more accurate determination of the appropriate “price difference” between one model and the other.

A potential objection to the adaptive regulatory approach proposed here is that it would be costly. But the costs associated with implementing such an approach should be put into perspective against the benchmark of “the truly enormous, immediate, direct, long-lasting out-of-pocket expenses associated with bailouts.” 277Macey & Holdcroft, supra note 2, at 1409. In addition, this approach should not be built from scratch. For example, regulators could rely on the regulatory infrastructures provided by examination ratings. They could also count on existing deposit insurance rules for incorporating bank governance into the determination of deposit insurance premiums. Clearly, these regulations should be reformed to provide for real consideration of banks’ decision-making processes and give actual weight to governance arrangements in the determination of both deposit insurance premiums and capital requirements. Nevertheless, they would provide an important institutional setup to start from for implementing this Article’s reform proposal. Similarly, in the case of large, interconnected banks, this proposal would fit in with the institutional responsibilities and powers that the Dodd-Frank Act delegates to the Financial Stability Oversight Council (FSOC). The vast range of operational powers granted to the FSOC—including (i) the ability to recommend the application of individual prudential standards, (ii) the power to request special certified reports on a variety of subject matters, and (iii) the implementation of studies about the feasibility of ad hoc capital requirements 278 See Dodd-Frank Wall Street Reform and Consumer Protection Act §§ 115–16. —would largely facilitate the adoption of the individual “negotiation” approach. Finally, in the long run, governance-focused regulatory intervention might better allocate limited public resources. On the one hand, after enacting this regulatory scheme for some period of time, regulators could begin to trust banks with advocacy models. This increased trustworthiness in banks’ internal control mechanisms could spare regulators the costs of more intense scrutiny, in part “delegating” regulatory monitoring to banks themselves. On the other hand, these newly available resources could be effectively channeled toward banks with CEO-centric models, which pose the greatest risk.

A more radical objection to this Article concerns the ability of bank shareholders to engage in active governance. Especially in large banks with dispersed shareholders, coordination problems could prevent the shareholders from engaging in the costly information-gathering process required by the exercise of voice. This argument, however, overlooks the fact that shareholders can always “vote with their feet” and discipline managers through the threat of exit. Bank shareholders could have acted in this way before the crisis if dissatisfied with their banks’ governance arrangements. Instead, they rationally chose to remain passive because riskier governance arrangements were profitable. 279 See, e.g., Rajan, supra note 1, at 147 (observing that the high volatility of the banks’ equity market was matched by high equity values). But under a regulatory scheme that penalizes banks opting for such arrangements, shareholders would have the correct incentives to actively exercise their exit rights if dissatisfied with the governance choices of management. In addition, the rise of activist hedge funds and private equity funds suggests that there may be great room for shareholder voice in large banks. 280Since the rise of institutional investing in the 1980s, scholarly representations of shareholders as passive and uncoordinated have increasingly given way to a new shareholder rights movement. See Bernard S. Black, Shareholder Passivity Reexamined, 89 Mich. L. Rev. 520, 522 (1990) (rebutting what he calls the “passivity story” as obsolete and superficial in light of the growth of institutional investors). This movement has strongly defended the ability of shareholders to improve managerial performance and accountability through active voting. In fact, in recent years, the focus of this debate has shifted from the possibility of shareholder democracy to its efficiency. See, e.g., Lucian Arye Bebchuk, The Case for Increasing Shareholder Power, 118 Harv. L. Rev. 833 (2005). These investors have both the sophistication and economic resources to be directly involved in shaping a bank’s governance arrangements. 281 See William W. Bratton, Hedge Funds and Governance Targets, 95 Geo. L.J. 1375, 1381 (2007) (explaining that hedge funds have been incredibly successful at using the proxy system to pursue governance issues); Marcel Kahan & Edward B. Rock, Hedge Funds in Corporate Governance and Corporate Control, 155 U. Pa. L. Rev. 1021, 1029 (2007) (“Hedge funds have increasingly tried to influence the business strategy and management of corporations.”); Ronald W. Masulis & Randall S. Thomas, Does Private Equity Create Wealth? The Effects of Private Equity and Derivatives on Corporate Governance, 76 U. Chi. L. Rev. 219 (2009) (suggesting that the great success of private equity funds is largely due to their superior ability at managing corporate governance issues). The fact that the Federal Reserve has relaxed regulations restricting these investors’ ability to acquire positions in banks and bank holding companies is likely to incentivize further activism. 282The combined provisions of the 1956 Bank Holding Company Act and Federal Reserve Regulation Y have historically required investors who gain “control” in banks (and bank holding companies) to register as a bank holding company, subjecting these investors to more stringent regulation and supervision. See Bank Holding Company Act of 1956, 12 U.S.C. § 1841 (2006); 12 C.F.R. § 225.1 (2012). In 2008, however, the Federal Reserve relaxed prior regulation. Investors can now seek to influence certain governance matters without being held to have acquired a controlling interest. See Bd. of Governors of the Fed. Reserve Sys., Policy Statement on Equity Investments in Banks and Bank Holding Companies 6–12 (2008), available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20080922b1.pdf. With the right incentives, the governance skills of these investors would add to the efficiency of banking organizations. 283 See Masulis & Thomas, supra note 285, at 259 (“There may be great opportunities for private equity to become involved in improving the operations of [financial] institutions.”).

A different kind of objection can be raised to the fact that this Article does not propose the mandatory adoption of advocacy models, given the thesis it develops about the efficiency of advocacy. There is a basic reason for this: for small, local banks, adopting advocacy models might prove too onerous. The requirements of having a board composed only of independent directors and a qualified CRO (with a structured risk management department) might be difficult in practice and excessively costly. 284Moreover, the costs that a bank bears to implement an advocacy model are likely to be private information. More importantly, these added costs might be unjustified in contexts where the systemic risks posed by a bank are inherently constrained by the bank’s size.

Finally, it is important to distinguish the advocacy approach proposed here and recent proposals advanced within the optimal compensation framework. As noted above, these proposals suggest that anchoring executive compensation to both a firm’s debt and a firm’s equity would per se provide a credible commitment to sound risk policies by banks. However, giving managers “non-partisan incentives,” by linking pay to the total value of a bank’s liabilities (including equity), is a task with serious feasibility issues, especially when these claims are not traded. 285 See Sepe, supra note 36, at 211; see also Bhagat & Romano, supra note 52, at 370 (suggesting that feasibility issues might prevent firms from implementing executive compensation packages that adequately calibrate managers’ risk incentives). In contrast, the incentive structure provided by advocacy is immune to these problems because it involves agents (i.e., the CEO and the CRO) who are left to manage their own partisan incentives. 286 See Dewatripont & Tirole, supra note 174, at 5 (arguing that advocacy systems are superior to systems where “a single agent is given a nonpartisan incentive scheme” to pursue simultaneously conflicting causes). More radically, because dominant CEOs can potentially modify a bank’s capital structure, the commitment provided by compensation schemes could be unreliable. In opposition, advocacy models would be more difficult to change because modifying a firm’s governance model requires time and involves complex procedures. Finally, managerial compensation contracts are always subject to contractual incompleteness problems, even if adjusted frequently. Both idiosyncratic and non-idiosyncratic factors, such as variations of the business cycle, could cause these problems. 287When the manager’s compensation contract is sensitive to risk (such as the implicit volatility of bank assets), it is exposed to the countercyclical effects of exogenous factors. For example, during times of high volatility, the manager could be too conservative with respect to the optimal level of risk. Conversely, during times of low volatility, the manager could undertake too much risk. Conversely, the combination of organizational rules and decisional bodies that form a firm’s internal governance structure is exactly designed to solve similar problems in a timely and contingent manner, especially in the case of advocacy.

Conclusion

Shareholders and debtholders have conflicting preferences over risk taking, especially in banks. This conflict is generally mitigated by negotiations between the parties. But when debt claims are insured, debtholders lose their incentives to participate in negotiation. Thus, bank shareholders, unconstrained by debt discipline, have no incentives to seek governance arrangements that constrain risk taking. Instead, in this environment, the risk-prone, CEO-centric model becomes the norm.

Institutionally, there are three potential responses to this outcome that can help to preserve banking stability. First, regulators can solve the debt–equity conflict at the investor level, mandating that banks be government-owned. 288Government-owned banking is widespread worldwide: in the early 2000s about 40% of bank assets in emerging market banking systems were held in state-run banks. Rafael La Porta et al., Government Ownership of Banks, 57 J. Fin. 265, 275 (2002). For a critical assessment, see Levine, supra note 93, at 12, which observed that government might have “less benevolent motivations than enhancing the corporate governance of banks.” In the midst of the crisis, Nobel Economist Joseph Stiglitz provocatively suggested that both the U.S. and the U.K. governments would have benefitted from letting troubled banks fail and setting up a new banking system under temporary state control. See Judy Chen, Stiglitz Says U.S. Is Paying for Failure to Nationalize Banks, Bloomberg (Nov. 1, 2009, 1:10 PM), http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aGR4KXaGwxd8; Ambrose Evans-Pritchard, Let Banks Fail, Says Nobel Economist Joseph Stiglitz, Telegraph (Feb. 2, 2009, 12:44 AM), http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/4424418/Let-banks-fail-says-Nobel-economist-Joseph-Stiglitz.html. However, the efficiency gains of this solution are questionable. Second, regulators can mandatorily require banks to compensate their managers with schedules that calibrate risk-taking incentives. However, compensation contracts are necessarily incomplete, leaving room for residual managerial opportunism. The third solution is to promote a corporate governance system that attempts to solve the debt–equity conflict within the bank. This Article has argued for this third position.

To implement a governance solution, the contractarian approach is the most desirable: regulators would substitute themselves for a complacent class of insured debtholders. Under this substitution hypothesis, regulators would discipline banks as debtholders would in a world without government insurance. Shareholders would respond by adopting safe governance arrangements in the hope of minimizing regulatory costs. But this change would require regulators to adopt governance as a centerpiece in the regulatory regime. Instead, existing regulation focuses on capital requirements, with only superficial references to banks’ governance arrangements. This blunt approach is socially expensive and maintains the CEO-centric status quo. In order to remedy this inefficiency, this Article has suggested that bank regulators should negotiate with banks over an expanded domain of regulatory options, offering lower costs to banks that adopt safe governance structures.

Framing the specific regulatory options that will fulfill this objective is a daunting task. This Article has presented a tentative solution, conceptualizing safe governance arrangements in banks as a model of advocacy. Under this model, an advocate for the debtholders, for example the CRO, would serve as antagonist to the CEO, who, in turn, would act as an advocate for bank shareholders. The rivalry between the CEO and the CRO within the bank’s decision-making process would foster unbiased decision making and promote more socially responsible risk taking. 289 Cf. Geoffrey P. Miller & Gerald Rosenfeld, Intellectual Hazard: How Conceptual Biases in Complex Organizations Contributed to the Crisis of 2008, 33 Harv. J.L. & Pub. Pol’y 807, 808 (2010) (arguing that intellectual hazard and conceptual biases may impair “the acquisition, analysis, communication, and implementation of information within an organization” and that these factors played a fundamental role in the 2008 crisis). To this end, regulators should make capital requirements and deposit insurance premiums sensitive to banks’ governance features. Small and medium-sized banks could receive a fixed set of regulatory options, while large banks could negotiate directly with regulators in a closer simulation of debtholder–shareholder bargaining. This latter approach would prevent an outcome where large banks exploited the trade-off between safe governance and lower regulatory costs in a manner that is privately optimal but socially inefficient.

Refining this implementation strategy, and developing empirical evidence, is a challenge for future research. But a discussion of the potential for advocacy in banks is a first step toward bringing banks’ governance practice closer to banks’ governance theory.

Footnotes

J.S.D.–Ph.D. Associate Professor of Law and Finance, The University of Arizona James E. Rogers College of Law. E-mail: simone.sepe@law.arizona.edu. I would like to thank the following people: Alan Schwartz, Henry Hansmann, and Jacques Crémer—for their continuous support and guidance; Randall Thomas, Margaret Blair, Paul Edelman—for thoughtful comments; Bob Mundheim—for his interest in my research; Chuck Whitehead—for a fruitful initial conversation on the topic of this Article; Barbara Atwood, Kathie Barnes, Jean Braucher, Ellie Bublick, Robert Glennon, Barak Orbach, Dave Marcus, Toni Massaro, Marc Miller, Chris Robertson, Carol Rose, Billy Sjostrom, and Ted Schneyer—for being great colleagues and taking time to discuss this Article; and workshop participants at the Vanderbilt Law School Law & Business Program and the University of Iowa College of Law Faculty Speakers Series—for useful remarks. I also wish to thank Jared Buszin, Amanda M. Baker, and the staff of the Emory Law Journal—for their professionalism and excellent editorial comments, and my research assistant, John Champagne—for his help in preparing this Article. Most of all, I am indebted to my wife Saura Masconale—for her fundamental contribution to the development and implementation of this project.

1Most of the books that have appeared in the aftermath of the crisis to analyze its causes include a detailed account of these events. See, e.g., Darrel Duffie, How Big Banks Fail and What To Do About It (2011); Simon Johnson & James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (2011); Raghuram G. Rajan, Fault Lines: How Hidden Fractures Still Threaten the World Economy (2010); David Skeel, The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences (2011); Joseph E. Stiglitz, Freefall: America, Free Markets, and the Sinking of the World Economy (2010).

2By one estimate, the amount of public money spent to counter the collapse of the banking system approached 80% of U.S. GDP, i.e., about $12 trillion. See Stiglitz, supra note 1, at 110 (citing Mark Pittman & Bob Ivry, Fed’s Strategy Reduces U.S. Bailout to $11.6 Trillion, Bloomberg (Sept. 25, 2009, 4:39 PM), http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a3mpIdYuoB0M). More recent sources, however, have suggested that $13 trillion was the maximum level of taxpayer funds that were potentially at risk, and not an actual figure of the losses imposed by the crisis. See Jonathan R. Macey & James P. Holdcroft, Jr., Failure Is an Option: An Ersatz-Antitrust Approach to Financial Regulation, 120 Yale L.J. 1368, 1414 n.134 (2011).

3 See sources quoted infra at note 93.

4Shareholder and debtholder governance can be grouped together as external disciplinary forces coming from capital markets. In this respect, three caveats are in order. First, capital market discipline has traditionally been limited to the market for corporate control—the trading of equity interests including both economic and control rights over the corporation. See, e.g., Henry G. Manne, Mergers and the Market for Corporate Control, 73 J. Pol. Econ. 110, 112 (1965). In recent years, however, an extensive scholarship has developed on the active control exercised by creditors on their borrowers both through market and contractual mechanisms. See, e.g., George G. Triantis & Ronald J. Daniels, The Role of Debt in Interactive Corporate Governance, 83 Calif. L. Rev. 1073, 1077 (1995) (providing a seminal contribution on the interaction between debtholder and shareholder governance); Douglas G. Baird & Robert K. Rasmussen, Essay, Private Debt and the Missing Lever of Corporate Governance, 154 U. Pa. L. Rev. 1209, 1217 (2006) (arguing that an aggressive use of covenants can “obliterate the difference between debt and equity”); Frederick Tung, Leverage in the Board Room: The Unsung Influence of Private Lenders in Corporate Governance, 57 UCLA L. Rev. 115, 115 (2009) (stating that the extent of private lender influence rivals that of conventional governance mechanisms”). Second, it is important to note that classifying shareholder actions as external or internal to the corporate decision-making process is not always straightforward. Indeed, because of the special status enjoyed by shareholders as residual claimants, corporate law provides them with several institutional means to directly influence corporate decision making. See infra note 121 and accompanying text. However, in large corporations with dispersed shareholders, the exercise of these institutional means is mostly mediated by management, to whom shareholders delegate operational and decisional authority over corporate affairs. To this extent, shareholder governance is external to the corporate organization. See William R. Baber & Lihong Liang, Associations Between Internal and External Corporate Governance Characteristics and the Consequences of Regulating Governance Practices 2 (June 2008) (unpublished manuscript), available at http://ssrn.com/abstract=1146922 (“External governance defines the role of shareholder oversight . . . . In contrast, internal governance systems concern the interaction between or among firm insiders, specifically, management, directors, and employees.”). Instead, in corporations with controlling shareholders, shareholder governance is better described as internal because blockholders directly participate in the corporate decision-making process. See K.J. Martijn Cremers & Vinay B. Nair, Governance Mechanisms and Equity Prices, 60 J. Fin. 2859, 2859–60 (2005). Finally, in addition to capital markets, managerial labor markets and product markets also serve as sources of external discipline. See Triantis & Daniels, supra at 1075–76. While the analysis of managerial labor market discipline is outside the scope of this Article, it is important to observe that, in the particular case of banks, disciplinary forces coming from product markets and capital markets are largely overlapping. This is because the largest component of banks’ creditors—bank depositors—also are the most important consumers of the special good that banks produce: i.e., liquidity.

5Internal control procedures generally include auditing and accounting functions. But in the case of banks, risk management—the process through which a bank identifies, controls, and makes informed decisions about the risk affecting its operations—provides the most important internal control function. See Christine M. Cumming & Beverly J. Hirtle, The Challenges of Risk Management in Diversified Financial Companies, Econ. Pol’y Rev., Mar. 2001, at 1, 2 (expounding on the importance of risk management in modern financial corporations, e.g., banks).

6This Article uses the term bank differently within the positive and normative analyses that it develops. In the positive analysis of the dynamics that led to the crisis, the term bank is used to identify collectively commercial banks, stand-alone investment banks, and universal banks. In the normative analysis, the term bank identifies bank holding companies. See Bank Holding Company Act of 1956, 12 U.S.C. § 1841(a)(1) (2006) (defining a “bank holding company” as “any company which has control over any bank or over any company that is or becomes a bank holding company”). The transformation of Goldman Sachs and Morgan Stanley—the sole large investment banks that survived the crisis—into bank holding companies justifies this choice. Indeed, this change virtually put an end to the era of the independent investment bank, giving these firms access to deposit funding in return for being subject to stricter regulation. See Press Release, Bd. of Governors of the Fed. Reserve Sys., Order Approving Formation of Bank Holding Companies (Sept. 21, 2008), available at http://www.federalreserve.gov/newsevents/press/orders/20080922a.htm.

7The standard economic reference on the debt–equity conflict over a firm’s risk choices is Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305, 334–37 (1976).

8The maximization of shareholders’ returns depends on both the managerial selection of profitable investment projects (i.e., the exercise of managerial effort) and the minimization of a firm’s costs, including the cost of debt. See Teresa A. John & Kose John, Top-Management Compensation and Capital Structure, 48 J. Fin. 949, 951 (1993) (“As residual claimholders, the shareholders gain from the reduced agency costs of debt.”).

9 Cf. Kose John et al., A Theory of Bank Regulation and Management Compensation, 13 Rev. Fin. Stud. 95, 96 (2000) (suggesting that when debt is properly priced, the shareholders’ ex ante commitment to contractual solutions that can induce managers to implement value-maximizing investment policies is in the shareholders’ best interest).

10 See infra text accompanying notes 139–40 (describing the various forms of debt covenants that are most commonly used as a firm’s commitment to sound risk choices).

11 Cf. Richard Squire, Shareholder Opportunism in a World of Risky Debt, 123 Harv. L. Rev. 1151, 1152–53 (2010) (suggesting that bank managers’ engagement in the particular opportunism hazard presented by contingent debt was in the interest of bank shareholders and, therefore, perfectly rational from the shareholders’ perspective).

12The contractarian approach developed by this Article draws on the insights of economists Mathias Dewatripont and Jean Tirole, who suggested that bank regulators should act as representatives of bank depositors. See Mathias Dewatripont & Jean Tirole, The Prudential Regulation of Banks 31–32 (1993). For Dewatripont and Tirole, however, the role of bank regulation is to protect small depositors, who are described as unable to exercise adequate control on their banks. See id. In contrast, this Article’s contractarian approach rests on the idea that the rationale for bank regulation is protecting the integrity of the banking infrastructure. Accordingly, while Dewatripont and Tirole articulated a representation hypothesis of bank regulation in the interest of depositors, this Article develops a substitution hypothesis of this regulation in the interest of society as a whole. Under this different hypothesis, the role for bank regulators is to redress the distortions produced in banks’ governance mechanisms by safety nets, substituting for insured and, therefore, opportunistic debtholders in disciplining banks. See infra Part III.B. Moreover, Dewatripont and Tirole’s analysis was largely unconcerned with banks’ internal governance arrangements, which represents a major focus of this Article’s discussion.

13In this Article, the term high-leveraged corporations identifies corporations that employ financing having priority over common stock as their main source of capital. These forms of financing may include, for example, preferred shares, subordinated debt, and other hybrid financial instruments.

14 See infra notes 162–67 and accompanying text.

15Because high leverage increases the asymmetry of payoffs from risky projects, even the undertaking of value-decreasing projects may be privately optimal for shareholders. That is, high leverage tends to transform the debt–equity conflict over a firm’s risk choices from a distributive problem into an allocative problem. See infra Part I.A.1.

16Recent economic studies suggest that the choice of better governance would be a standard means firms could use to lower their cost of debt. See Viral V. Acharya & Paolo F. Volpin, Corporate Governance Externalities, 14 Rev. Fin. 1, 3 (2010) (“If firms need capital to invest, for example, via a public offering, firms are forced to choose a high level of governance to meet investors’ demand (formally, to meet investors’ participation constraint).”). This observation reinforces this Article’s thesis because the higher the level of leverage, the higher the need for better governance.

17Shareholders, as residual claimants, are concerned that managers will pursue selfish interests rather than exert effort to maximize profits for the firm. The use of equity-based compensation mitigates this problem by aligning manager and shareholder interest through stock, stock options, or other similar instruments. But it also gives managers their own reasons to prefer riskier projects, to the detriment of debtholders and potentially to society as a whole. See infra Part I.A.2 (discussing in greater detail the effects of equity-based compensation on risk taking in the banking sector).

18 It is important to observe that an analogous result occurs when the corporation is controlled by a blockholder. Accordingly, this Article uses the term CEO-centric governance model to identify both the governance model of centralized-management corporations with a dominant CEO and that of controlled corporations with a controlling blockholder.

19 See sources quoted infra at note 174.

20 See Basel Comm. on Banking Supervision, Bank for Int’l Settlements, Principles for Enhancing Corporate Governance 17–18 (2010) [hereinafter Basel Principles for Governance], available at http://www.bis.org/publ/bcbs176.pdf. The Basel Committee is a committee of bank supervisory authorities established within the Bank for International Settlements, whose mission is to promote international harmonization of banking regulations and, in particular, bank capital regulation. See About the Basel Committee, Bank for Int’l Settlements, http://www.bis.org/bcbs/about.htm (last updated Oct. 7, 2012).

21See infra text accompanying notes 231–32.

22 See 12 C.F.R. § 225 (2012) (setting capital ratios for U.S. banks); see also infra note 229 (providing an overview of the basic principles of U.S. capital regulation).

23 See 12 C.F.R. § 225.

24For an introductory overview of contract theory and its basic results, see Patrick Bolton & Mathias Dewatripont, Contract Theory (2005).

25The Article also generalizes these numerical examples with a model in the footnotes. See infra note 38 (providing the basic setting of this model).

26Historically, access to deposit funding had been restricted to commercial banks since the Glass-Steagall Act prevented investment banks from engaging in deposit-taking activities. See Banking Act of 1933, ch. 89, §§ 16, 20, 21, 32, 48 Stat. 162, 184–85, 188, 189, 194 (codified as amended in scattered sections of 12 U.S.C.). However, with the liberalization of investment services by the 1999 Gramm-Leach-Bliley Act, many U.S. banks turned into universal banks engaged in both commercial and investment banking. See Pub. L. No. 106-102, 113 Stat. 1338 (1999) (codified as amended in scattered sections of 15 U.S.C.); see also Matthew Richardson et al., Large Banks and the Volcker Rule, in Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance 189–91 (Viral V. Acharya et al. eds., 2011). Moreover, after the 2007–2008 crisis, the transformation of the surviving investment banks (i.e., Goldman Sachs and Morgan Stanley) into bank holding companies has extended access to traditional deposit funding even to these banks. See supra note 6. It is worth observing, however, that even before this institutional transformation, banks of all types had already found ways to synthetically replicate deposit funding. See infra notes 87–88 and accompanying text (discussing the progressive increase in modern banking of the use of deposit-like products, such as repurchase agreements and commercial papers).

27While “liquidity cannot easily be apprehended through a single statistic[],” in general it can be defined as capital that is available for investments and takes the form of either stores of value (i.e., cash) or real claims (i.e., credit). See Jean Tirole, Illiquidity and All Its Friends, 49 J. Econ. Literature 287, 288–90 (2011).

28 See Jensen & Meckling, supra note 7, at 334–37 (illustrating risk incentives of equityholders when a firm’s capital structure includes debt).

29 See, e.g., Philip Strahan, Liquidity Production in 21st Century Banking 3 (Nat’l Bureau of Econ. Research, Working Paper No. 13798, 2008), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1092846.

30A liquid investment (i.e., claim) is “one that the investor can convert into cash at a price [equal or] close to the present value of the future cash flows of the investment whenever the investor so desires.” Jonathan R. Macey & Geoffrey P. Miller, Deposit Insurance, the Implicit Regulatory Contract, and the Mismatch in the Term Structure of Banks’ Assets and Liabilities, 12 Yale J. on Reg. 1, 7 (1995). Banks can maintain this structural mismatch between illiquid assets and liquid liabilities because of their superior ability to generate private information about specific borrowers and diversify risk among many borrowers. See Douglas W. Diamond, Financial Intermediation and Delegated Monitoring, 51 Rev. Econ. Stud. 393 (1984) (Swed.) (developing a formal analysis of the informational advantages of financial intermediaries).

31The seminal model of financial intermediation and bank runs was developed by Douglas W. Diamond and Philip H. Dybvig. See Douglas W. Diamond & Philip H. Dybvig, Bank Runs, Deposit Insurance, and Liquidity, 91 J. Pol. Econ. 401, 402–03 (1983).

32The concept of funding liquidity risk concerns the distinction, recently introduced in economic theory, between funding liquidity and market liquidity. See Markus K. Brunnermeier & Lasse Heje Pedersen, Market Liquidity and Funding Liquidity, 22 Rev. Fin. Stud. 2201 (2009) (introducing this distinction with respect to security markets). Funding liquidity involves raising cash on the liability side by borrowing funds, such as when a bank issues deposits or long-term debt. In contrast, market liquidity involves generating cash on the asset side by marketing assets, such as when a bank sells T-bills or other easily tradable assets. See Tirole, supra note 27, at 288–89. Accordingly, funding liquidity risk “arises when it is prohibitively expensive both to (i) borrow more funds (low funding liquidity) and (ii) sell off its assets (low market liquidity).” Markus Brunnermeier et al., Int’l Ctr. for Monetary & Banking Studies, The Fundamental Principles of Financial Regulation 13–14 (2009). Because of their business model, banks are inherently exposed to more severe funding liquidity risk than non-banking organizations. Indeed, bank assets have lower market liquidity than industrial firms’ assets, and bank liabilities are considerably more liquid than industrial firms’ liabilities.

33 See Diamond & Dybvig, supra note 31, at 403.

34 See id. at 402 (“[B]ank runs cause real economic problems because even ‘healthy’ banks can fail . . . .”).

35Asset substitution is not the only means through which shareholders can act opportunistically against debtholders. Other actions that may illegitimately transfer wealth from debtholders to stockholders include the payment of excessively large dividends, the issuance of additional debt, and the rejection of projects with a positive net present value when the benefits from such projects accrue solely to the debtholders. See Clifford W. Smith, Jr. & Jerold B. Warner, On Financial Contracting: An Analysis of Bond Covenants, 7 J. Fin. Econ. 117, 118–19 (1979).

36It is worth emphasizing, however, that the risk of asset substitution may be severe in non-banking firms too. Many publicly held corporations besides banks operate largely on debt, including corporations in the following industries: auto and truck, property management, natural gas utility, advertising, electric utility (central), homebuilding, maritime, newspaper, office equipment/supplies, packaging and container, power, publishing, and trucking. See Simone M. Sepe, Making Sense of Executive Compensation, 36 Del. J. Corp. L. 189, 209 (2011). Moreover, in the vicinity of insolvency, asset substitution becomes a threat for any type of firm because the firm’s equityholders no longer have any expected liquidation interest. Therefore, they prefer “any share of a favorable outcome to the zero return” they otherwise expect to receive. Barry E. Adler, Bankruptcy and Risk Allocation, 77 Cornell L. Rev. 439, 463 n.99 (1992).

37The examples in Part I of this Article focus on the incentives of equityholders (i.e., both shareholders and equity-based compensated managers) for increased risk taking. In other terms, these examples assume away the consequences that arise from the debtholders’ rational anticipation of such incentives, postponing this discussion until Part II.B. Accordingly, the basic setting described in the text above assumes that the interest portion on Bank Alpha’s debt (i.e.,data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABcAAAAQCAIAAAByTXNPAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAQlJREFUOE/NUzESgjAQTHwLUDi8ILxAbKxo7ZJSHmBpZwOlPIHe5Ae8gLEg /AVz4CQXYWQcG69i7jZ7e7cHHYaB/BybnxmAYM6ihFBfU5uJXEhu37NCvxW4xFBdsAkLQKxFiZTI QXID1wWp7z2A+jKhlF7a15tXFyXCPAZWA8yPJXH8hh14R5b3gM4obTRbrfCNtASnc5yHNK1Wt9J3 rYdpvO3ubiCRVSlNynGcDxFHwVQNt2zuURDFXOqsDlecajvUZ/legn3GPJgvynRyCf1o8F6UoLa/ KVnJC2PtDrzJr3BWfXmpWIY8gpXYF84QnCXOKHtagMQsk72LTs+s9xP0r//G1ZtbADwB3WcQjgbr Yx0AAAAASUVORK5CYIJ= ) is negotiated in competitive debt markets (i.e., under a zero-profit condition) and is given by the debtholders’ participation constraint. The participation constraint (or individual rationality constraint) is a property of optimal agency contracts and is satisfied when the contract leaves all participants at least as well off as they would have been if they had not participated. See Bernard Salanié, The Economics of Contracts 122 (2d ed. 2005).

38The basic example and its subsequent modifications use binominal distribution to represent the problem of risk taking in banks. This problem, however, can be more rigorously represented through the property of second-order stochastic dominance, which compares distributions based on relative riskiness or dispersion. Mathematically, this can be expressed by observing that if two distributions data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABYAAAAQCAIAAACdjxhxAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAOlJREFUOE/NU8sRgyAQZVOL5pBJBViCd0vQq6VoG7lHO6ACJwexF7LCgiA4 ScZL9qS4+/Z9EJRS7Fxdzo2v019ALH0BRb/QrrEBaMZgMQpRaqh3ZOpBnyvZccY7aV5cYbt3yLZW O4aA1IAA8byFdl8IIsSldccIhh7tNF4s88SrMsOHvnBCl+dD3K94mKqsrPg0a4M0xNos2hwA8pbd 8vRQ7KN4SQchX8Iok12tyfxWJo+Ua57cXSKUFQ2hEDSCpTR7cmNWvlH2SrhIvY3HPPywKNQEU3e1 YvAw7Q8Q9upuXq2sQ+fgL/7UNyC9sh2uJHPzAAAAAElFTkSuQmCC and data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABYAAAAQCAIAAACdjxhxAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAOVJREFUOE9j/P//PwNlgIky7SDdRBhxZ6I1o/XEOwi7tqczMqZvR/CBHoGC bWkI0bRtEMHbE6wYrCbcRihCUgwTZ0AoZYDqA2pDsLDqh5kOkQQbgcMuoDBuEyC6QHaBjAD5AOZy JCfDlGD6AioCtQIYnNs3zGJIC/AkImrQw5GB4di128AYuXPrCoOVlirYBFDggwByeBM0GhKpOmoq YFolvwbsqZnY3eQ58/9/VCmw3ahBgRIsJAQnODwhIA0IoEkCGlNYwhmeDpAiFWeYwyMOQwWSC6FJ C7chEI+ipA80AcZBkVMBQWzQcb3dJeEAAAAASUVORK5CYIJ= have the same mean (i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAG0AAAAQCAIAAACTJmYeAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAoBJREFUWEftlz1uwjAUx196hkqoY8WHEOIE4QTAwpS1UgfTDQ7A2I0lGUHq BZhYSE5QToAYSO6S2nHs2MEJttNWDHgBLPv59/5+H8ZJ0xQeo7ECT6KFJBg5eIyCpLHd/zRwD9iC jknwdl6laYj+TgPiseKWornjzCPLY+8EG+c1HbHvun7Mf5p9oeKjEO9S3EM2j+1DzQF4m9XxjbA5 bkYoSlFcqtvXwQa+GTsiWzNWkm2XXMM/yLyGuxpLFEgNsamSguPSdcer11b/RnBRbJ7XyeVkmVjZ tmi/RbMxtRCfwZt2AJIgiKDT8wZdSA47OlczOlMPlutSepOULw+xMjTELpFDNO/uvPh7wUifX9of Wtg8Hkk6luKRXA3QoM6S9Tpc8xxGoXinIaIJyj7znOa7q81aRKQCOz/Pilx2kpBqYtfpSLIoK1s+ UmR8Jgedl5wR6qPEIJlQm5W49cqKWkdrcrlEX/FUY9/SUdZILsVcGSHyiiiMfcQry7VASv8VOqpe D6Kz1TpakBfRSHMGoFVKwkps6f2oXyCj9XIYbmg9jOaTE6t9SfDJv8OgV18QVce5uJiKY7y5jsui fOkD85VV5EAqLT8d12qc0l9+W/MEV9Sx7EOm0X4Wou2+8nGH+8Bk63IZhXbSWSzyvgNAsE6X4nWv Noub0XForr0C25yc6nXcHSgkQUGzd31sMa+lCkYjO3+yENNyiWT5hkK2kKWCqh/R12NhTGnWosuU Hy3sIWxGziJeqCGum73W9LGZjlZO6LWCfNWNJmIHYLfLhFsTG3A5JsqLrcLkGLO15MYV/1oqpmtt 3xk25Olo9Z/MTMRfXX1v2A72TrMnPZbVKPADzn8qU4VhR84AAAAASUVORK5CYIJ= ), distribution is riskier than distribution if data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAJkAAAAQCAIAAACKgUr9AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAvFJREFUWEftWD2aqjAUDW8tOMX7XAGuwJnGytYOSlyAO5hGSulsrWiUFQwr 8LMY2AvvJiHkBhIgOiNv+IZqxlxzOefcX52yLMnvMwkG/mAURbRw4FlExSSwWYGYAHakZRFtbruy vPgDOaDo9bKngeME6cBrBpl9t69pYIcay59873n7vP63/gNpK8/BmGit8de6DahD0NG/VF9pxZA4 +QpfbVjKJ2NjZy+DCbgLO8Hk17yq0KkT5cgEXf1avxVYoHupZkjZKhL6bzEFYuu1zYKC6fjYxStI Viyx11oqTCLUGpjDXLBMN1HEHVx8nLrgqZ3JD/qqYn1AhdBp+Szshspji73ul/kt03Wu4vPq/Z0p J8X5lM1f3PozPjWw/kgbpeyU7tvau3625ihmRO2CJEb3UE/rN7gW7qub7aO+lgcWNEey4S71TXxk 7On7NvN3oWSUU2uNXZljNWK64W6+nXXwQNIzOUIExUkULZIVEHdYonuyW67cCkK+XnlbXpHYX9W2 9M0z5mm2JY3oqW+w8yUdu+EH03SV2EzpT8KeJjFBRJhmwX7sPVpCjrzGvPwoEiGHyzB0aQbGJ3I0 2UgxktjbH1kINjIecoNXwnzvs/TUPVa+8AVVLaCx9tFKAAN7T8IOPBBR+qrFSFs/+rF3apkGM7ql 9CrUsVaoBRpCkNdRVkEI0kyeuOFhKNsNv81mIIo+5DorGFZInoidENFqoBKwOdOecYoda9lqjBAx mn7XaoMQTRuy9rPTuSiiSLakZsFH1ANTW9p004C3MBqcuAcL00d80VysNOwPx/Gwuy9zEicVa7je 2mMXI6t+LOc7YHMaRQMqHRR5bWQjIx4YdWOY2KH8C94u5aftteF+X+YVpHkyJnZ1s/ThEQu3sggM 4VnsJJ3zbxtr77ph/OlhOMPC8l5fhh+wLPeeH4SdQD7RSFBXvUFLvwwVTZz3/Cpkq+g3+ZoWdlJV UeM2PXRhtVXnf7CfGHYHOO0YQ3+PfhAD/wC7QnpX+idcjwAAAABJRU5ErkJggk== , where data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABMAAAAQCAIAAAB7ptM1AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAOxJREFUOE+dUjsSgjAQTRyPAhaMJwgnYOxt7aDkAh4CSu1srWyEE8AJHArD XeKGXSUfMuOwXbL73kveW66UYqtqswqlQWHkWKc8rUdibgvOi9aSUU3ORCXh0UbJSviXziSDeT1H lTd49riQ1uxoJJCZk2Egikzs4KsnYTTtLziq4FBUdjd24lCzIbMVvjX9IMlb6MXDWTN2ZfR/SFvW Pq7wyywEyS7uqogkRs04EaSP4OhwFK/3N0eHcHze+/0OX0Zm4wTaFvbIS4U8hJ0gx5exdlyT5i9m Ak5n4DH2yD5Rnt52LMS4cMX1NqyqD64ApUo4aVM8AAAAAElFTkSuQmCC is a concave and invertible function. See generally Andreu Mas-Colell et al., Microeconomic Theory 197 (1995). To this extent, second-order stochastic dominance better captures the concept of tail risk, i.e., risk that occurs “in the tail of the probability distribution.” Rajan, supra note 1, at 137. Indeed, we can say that data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABkAAAAQCAIAAABshEP8AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAOlJREFUOE9j/P//PwOVABOVzAEZQ4RZdyZaM1pPvIOwdHs6I2P6diyOAPoR CralIaTTtkEEb0+wYrCacBuhCEkxhjgDQg8D1ACgfgQLq0Ewa9AkwWbhsB0ojNsoiC6Y+8Gmg8wC eQ5FEOFWLMII/6LbBQz77RtmMaQFeBIRoZiBfuzabYQ+JoY7t64wWGmpgoVAUQYCWGOJoGWQNKGj pgKmVfJrwP6did2VnjP//0eVgjkCYg9qcKEEHTlhDw58CEgDAmjSgsYvztDHtAmavjATI4G4xOZm AmaBTAS5GiWdYQhAXcI4SMsJADSMGDjkRUNbAAAAAElFTkSuQmCC is generated from by taking the mass from an interval of the distribution and transferring such mass to the endpoints of the interval. See Mas-Colell et al., supra, at 198. This implies that the examples in the text can be formalized by using second-order stochastic dominance with discrete distributions, as in Bruno Biais & Catherine Casamatta, Optimal Leverage and Aggregate Investment, 54 J. Fin. 1291 (1999). Under this more rigorous rendering of the problem of risk, the basic setting is as follows. At data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAoAAAAQCAIAAACgHXkXAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAJtJREFUKFNj/P//PwNuwIRHDihFFent6Yzp27HYAzF8+4ZZVlqq2Jzx//YE K7i41YTbQJ8gAQYQe1saQ9o2VHEoD2T4nVtXcBgN8tidrasYwrxVsAYAUPr2tWM6akDZ7elQxwO9 YT3xDlg5UFpVy2qWFyMj44aAmZ5AsyZab9CaoAMzC5uLbk9Ig3qBQKCCPYYCYOEADgNG/BEKANAo fx/6scEnAAAAAElFTkSuQmCC , Bank Alpha, having equity data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAcAAAAQCAIAAABV4/KnAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAFRJREFUKFNj/P//PwMGYMIUAooQFN2ezggDDEBzYWBbGoPVhNsgHpIoQhBJ FCEIZCFphzvHCiaKrNJqAlQUyUyEbSiCtycATQARqMBqAiM1wwHJcADOMHnIAc46DQAAAABJRU5E rkJggk== , has the opportunity to invest in Project I, which requires an outlay of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAcAAAAQCAIAAABV4/KnAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAFJJREFUKFNj/P//PwMGYMIUAooQEN2ezsiYvh2qE6j2zkRrRkbGlitWCMOA oir5R4FWLgxDsoEs21BcSIoJDEDrb09AchRD2rb//xmpFw4oLgMAvJsYmrX15sUAAAAASUVORK5C YIJ= . Project I, as well as the investment opportunities that can materialize for Bank Alpha in a following period (i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAoAAAAQCAIAAACgHXkXAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAIlJREFUKFNj/P//PwNuwIRHDihFFent6Yzp27HYAzF8+4ZZVlqq2Jzx//YE K7i41YTbQJ8gAQYQe1saQ9o2VHEoD2T4nVtXcBgN8tidrasYwrxVsAYAUPr2tWM6akDZ7ekgxwP9 AAEQn/yHuw3F+m1pYGeCnYYBoJJYpZH9gaEbKAkBYMMZ8UcoALiapZZFENmYAAAAAElFTkSuQmCC ), has three equiprobable states: a high state, a medium state, and a low state, with the following payoff: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACwAAAAQCAIAAADiXgqAAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAATRJREFUSEvtlc0VgjAMx4truIDP5wRlAhdghDKBGzgAXBnBUy/CBk7gDXbB pk1KirRyg4M58CjNxy//tI9sHEextR22BoD6e4Poysxa2QFduErqha55PUxu+M3lSpj1E+ZMkLVK CNXSqq8kWzG379dWSSmFrHqeiedKRENRNo5ON7K6XRF7eD5e6qizoL/lljr9LoqL3xvqXJ9NB6fm zrWJxZqikxIGifXidYAXMLY368voUPXen6/WxEJiDwGyhDZNBqpSwvCr2bBV7bZqzRP255NMxNrm CCKiw9L8Q1UcA7BACxYxeprAhytKRRFiBQO2M1OCGAAC8y8wxGIxxEGkGGhOi4fCM0yScYYfsYQt /LDxPlKc7Ti8tPPZONcAjkUnY+mUuFOY/f8deB339u/Y7n/6AeUgyerqewP3AAAAAElFTkSuQmCC . Project I has a positive net present value: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAGIAAAAQCAIAAABiLT2TAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAkZJREFUWEftVjGWgjAQHTgLWvA8AZ5Aaaxo7bDExm5LOxootdt2q21WTiAn 8FEId2GTQCQhJARki/WZSmJmMvnz/8wYZR4tQ/AA3FNgwXt1I2CCFVxP7hseNQJmD0BFvDSWcfFv YEx2hrFLpg+3RKpziFsnyktu4T+azYvPnKI2/oU30fiq/bCWlTfhfg1nJRdVbYD2Rvni76s9V65A GguKnb+MRw1/yUBCNyjwyyPf9xnffSD1eWNzWb9GiF0HceEMA7dUdMXPF3guW9TzLHWaHfTlb1Zj 2J1nYNuNYRJmHsoIf9cgv6Kt5XqwD5/UXnG/PcKQwYRQShdzFiVs1ewk32fHng16TX24uIPtzhdp luONZHe0N9C+S9+vGCexRTg5t3u7pOLC1bEUtbd+cNFXwh8B43jgvKa3rM8j849ZOrdmNnlFEX/b nwEgmo6DHEBB6joRDOSrU6f4rj2TUBFvzRa60jxiyTU1HsmW5xohRoMhA2grV3m2oFrN4222CSxM TFFyet7Gk1qbsAik7ENWwtsVmu8e6qqK24+8uldgkz5CDql6AUm+whtbqtFv5tLOIk6bVwsiSVsk T75EPo5XJrqWuKcqTCj7FQuR6pzogFoAFvMzkqOkTsL9g6aVV4HuMFh06f4IByJJ1UBAOUGzUGWr a1QRRo5ONokjk878JWMTtaXcYEgxyUDACkgOk4YcZBD3aHLgEDPY2yQg8UGqYKLUmWCkHYjM+OOY sH8QL1AN1QV1fIAvbWnSuibpAtp987UP/gI2SeKVXdM1/wAAAABJRU5ErkJggk== and data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADUAAAAQCAIAAAA55aCiAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAUBJREFUSEvtVjsSgjAQXTwLWjieIJzAzhvYackFvIGNlJTcgEpPoCdwKIS7 xGzIJgHCz88MzrhVFjZvX3b3BTzOOUzYZhPmhtR+ht9l70kLogJ5F1Fgu0OqjAj7y5DIjhjKSzxA zJ+y8w7YKScvPzHLM1GulYgVKRljsDt3R/a8FRRKCESU6Q0//QgxhDM6FQK0bKoevZWkHabW1flb LfyyudvsEK/fbJW1fR3zBLZ9A1M87pWUtyx36ePj7GRSP7zKuhHPlklVFQKYL3Fmmvzq7Eg3pXq0 KRmNLzHx3KRaizbI/SHlqc30N89ubAnREZJKZ0VrXHYN5SS8YEqh6YbzGoi/WBk8SWcORh+oHVvA o4XYoQ/Ekvg9Kbr0O1BjTtrlBUPWFLHO23toOgXdBN7/+/vCjLr08RbM1zZP/f/gCREUgbOMFuuL AAAAAElFTkSuQmCC . To raise the capital needed to pursue Project I, Bank Alpha issues debt data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAgAAAAQCAIAAACk6KkqAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAGJJREFUKFOtkNERgCAMQ4tjMZDzMA3LdJgYjyqpB3/2jxfS5FoA2GqOJSXc CsZVMf1M7imASm0+QM+Ol7ORbhI+Bd3Dz/44PpzPyJJcJt/9RgftQ8owg7ea+keD8t+ttke8AGgx ocClKydmAAAAAElFTkSuQmCC , where data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADYAAAAQCAIAAADS0huhAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAARVJREFUSEvtVsERgyAQhNSSySsVkBLyTwnajvmmirykGNMLAUG5OxBO89GZ 8BI8dvfuFgZpjBH7Hqd9y3PqjiVRtxKNVm+oMAWRcguMQ4n7rBen0TdCdYOf2W8hmh78DavJWhoy g5ihU7V4st3usMRKqUgu8gq9xsgVouxihRKmSdhXTJ3QmSh6Ub9f6nE/w+ZeL2jK6HsE0e3t+QE7 UgeMrsJBeYZcl+0aygNaoVjF0R5hJC3YWsWp0aRBjmsWA4lBnqmGCNI3vyjEBQoSsUIkECZf9mLR h+w8HR/qoZdIz/JSCYoSkcL1ZxmWgkj0x5znoUWJFCRzGzCtiJGc2cClw8CoXzoMkLUh8v+MYNyl tZADPCO+XsNNLf7+a88AAAAASUVORK5CYIJ= and data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACoAAAAQCAIAAADvQHrHAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAPNJREFUSEvtlc0dgyAMxaGTdA4HwiF66gYu0DV0GIdBCQTy+BAv/dFDcxLL yz/hBauttWpcPMahHfl38NusKebN1YWryzPirV7OCXrHSip1es+xGqXMyqt9mcRKbCsfT+G07P69 S3JPRzuBHpNYS/S3yNsuQNID//kK1XRUCY9JYu/uwYWoLEuJQmrffG6qIp6OAiL54HhcBr71py1L Q896KsY3eq/6DLha73F+YKxkkawK+Bv00EjWfel79dBaKo+/orMrVfPzmccL0BqZpFLR1HBbmEb1 4lXMnGBfeWAAXYyIvM9pxPT/m9/7Pn7v98F/OQciRf46yCgOaAAAAABJRU5ErkJggk== . Under the assumption of a competitive market, the interest rate, data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAsAAAAQCAIAAABP3xIpAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAI9JREFUKFNj/P//PwNewIRfGiiLU8X2dEbG9O34VDAwWE0o9cSj4s6tKzpq KiAn4LLl9jWdAJAJQPD//7Y0IJW2DcqwmnD7///bE6yAlgAZIJ9OsErbBhQAAqAqIAOkFAUAzYBo xpCBKQOpABkBNRJNP4gLdOmdrauOQd2NNfjAduC0AmgGIy3jBe4kwnELAHP6lmlQj99tAAAAAElF TkSuQmCC , is determined by the following participation constraint: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAIMAAAAQCAIAAAC6DVvcAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAthJREFUWEfdWD26qjAQja7F94r7uQJcAdpYuQQotbndLe1osJTO9lU2D1Zw WYGfhbAX3iQkkB8CE+Xej/tSAU4y58yZTCbOqqoidGTh6vH+uV+wl/9/lKdVRHaEbM5ToTyvg56F x7fLVDB9Rx4s9p/nzXc4QvugSmTh7LrVtwMkzYyNMMMtRiesTiXO2NEKENY4mgeRQDXGsf3auWgA HHn0mldpwH/34gJKlRhF7KkfGjtmbhirX6hxkErLvfaYBpI/WFvxrr/jXAG/DiIwl/7Qrs9Zj+DQ hKVGlNhwG0owiDy6jEaDTjGtGXpeY9vlADC46ARrKuYqtj4lHB0xHQaSjPIxg4OTX7OSkaf8nEDu Mu/tF7Nc7C+xl98L9lL+/UN2G3HUQwEGfxc4DMcbxX259aXlFpsdOUTIqukEQ+UiikXLjn8ZB0B2 TbxmaR+vBIDMl7/l3ur2oKeC+d2Ju2ZM6zA7EtgDq//l6ZjUrpoBkfC0T684beaaXCzsugEwzOaw nGKKEITglSjueaBkJlF1GSEUcFBet7Dzb8cV9BDwwDzQXdbRXostOYLfniVM1o2xCcA/dxap7ruB JkQ51yS0gqITeW3iG0F6xUWjTZl1QpK18NymDG0tfeCeLz+qs8/ecCt3bSy2vMUReY71U2AskzQh smiuqWhzVj5ubU0jWXTIgw/X+0ebMspBqqYMdRS/IxToSYRhR0+whg2rNvQmAIfqpAqRhesEW50g U0UxAn/rJEhFvo5bs3GnDs7KPYV1LjLr6CC1Dd0A8NVJFoLG8xYXqC5W9N6cmt6ASu0t78fbGHQ3 q/bmEtV2fm0Xq7TqkppSd/tSF6tFU9wGUEoMNsuqFoPm9Dbpcp9QF9TDMOp9or7Z9YN7SQdrcPqU qPMBGzJ6Y1QvRcOKOFtoTsQtdWy/di5fx5K0/3ZgQ+4cvilOaP5pmAzrOeHHjPYniPtp97NmTI/1 P40de1fHu1quAAAAAElFTkSuQmCC , from which data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADMAAAAQCAIAAAA0+9DlAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAT1JREFUSEvNVssRgjAQXa1FPThUgBU4XjxZQjjahAXIUavwFCrQChgOQC+4 G/IhTAIq4LCnDPt72X3sBqrRhTPGZVDOwmtBZ31wZrO10n8JE0qZp8FmZSdIooWRXVyi1mUG4EVG EaLkF9jrLeSUEKDIguOeDskjPR1qiPtbo2zPM31UZklMQMsctmuy9DWzu/7dFKj7UVxDdTHdXoef MROd11zwIUP7rnB95OQMJMP6LJt6Aqmz+pA1aPxN7BFtkWeCk0QpcRCkLOPLPZVkaVDNYm+bx79Q stOHuoZVRMFCDuzhiBWrKtFNZIXp79Dwo9UOgVDJ6oHYI3QDh3zm3Be8rceaWX/Et/7T2eMfUGQv Vg/EWckCLz0rQBrMpHtz0JX/gkzPQbWIzWD0r+a/IJNbnDMzvdXrCC7iueGQN3v+c4eTuimNAAAA AElFTkSuQmCC . Finally, data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAE0AAAAQCAIAAADce2XOAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAeFJREFUSEvtlj2WgjAQgMOehd1inyeIJ0AbK4+AJTbbWdrZYCmd7VY2CyeQ E/gohLuwkyExRAKMsPvePt+mCmEyk29+MnHKsmRPNZKVM4saRM7TcdqD9kKKZbGfOtN9QZIdIAQh cFYJbLxNBijp2QLxLMvYr0vxMMfVauQhZ8aKEPbjmsToaezXDIB68wAPqrezMA0jzy64tCX40lbx F+Oc93CCqUccAWoNccPmg5QyMA0Wnbf8/RWD6gbHkKdZjh/F1ydbzl0ZbTc4g57j8oezKs8mC6+m 050v2Xon8njoaLJUnICTTt4Ujli5XEU1NteHWpb7RAFiKeIES77Yb6PK2m0AKL9bQvnmsFwadpaK M89S33ApM6lH0sntcJudFpCUl+3UwQkaEUlyDuo+RnGVUXKvd7AmsGWjnQU5k1OkIi2DWPskM2qX Q/+KZsr52uVAdPDgGOlkUx48/CIrJwu2sAjO4nrhugiT3Tr1N00H91rSLjfuIdPlwlb4QeC78zQ1 b9tYBCe4WKUpPib8WDnaUii9uJ0CtIK3SFHztpWl6hW3cd8PxG+9Zgq39o72vkLqOIP7SgeL7J8d XcokJbUzEk2bpsGUnUfr51TvpVGPFJJ7qnfZ79j5f8ePu3D+2u5vQtLaGOyjQM8AAAAASUVORK5C YIJ= is the face value that must be repaid to the debtholders at maturity (i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAoAAAAQCAIAAACgHXkXAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAI9JREFUKFNj/P//PwNuwIRHDihFFent6Yzp27HYAzF8+4ZZVlqq2Jzx//YE K7i41YTbQJ8gAQYQe1saQ9o2VHEoD2T4nVtXcBgN8tidrasYwrxVsAYAUPr2tWM6akDZ7ekgxwP9 AAEQn/yHuw3F+m1pYC7YaagA6FAGBqgfsEiDFUM9gyEN1gsCYMMZ8UcoAN4Yo4WsBnbmAAAAAElF TkSuQmCC ).

39The property of second-order stochastic dominance perfectly explains the risk preferences of shareholders and debtholders: debtholders have a concave schedule like , while shareholders have a convex schedule. Therefore, the following condition applies to Bank Alpha’s shareholders: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAALAAAAAQCAIAAAA5yWLnAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA2JJREFUaEPtmDt26jAQhsVdi0lxDyuAFZA0VLR0pjQLyCJwiTtaKhriFYQV cCiC9+I7etgeySNLMuYm5wSqxNbj1ze/RiOPyrJkz9+TQEXgD0ZRpLMR/GZp8QTUIvBL4CBDFOnq +l6WH7GnGzgh2jv5ejRa5+5hoN1Q5rtfTLfc/w8H9HwLHzgy5O+2nU63t/rf+g9kkOY9NGZka9yt uwEMEW+3MTVlI4LPw1j8oZ60zCreDCCmvWz9iQ0OtGrzGUZPHz76dq6wBelhOII1eJ0GX7L2qgMP 6qm10kJZO+XmMoSINpqbrw3Zgw/UQ0xn+El8IN8CR1miedtPzxB8xO5RQhpsgXpqQ2ioETEChd8U cufaMcqs5MgQ3PI40YAaI+8MJ0bFhMprHSsx+QynJ5CPJQ+E6qkN0UoD1oPEpIPSumDqu1lkP0Ye PdWGiWNta9arqzfAAGLquaqDiT42aWubvAfQg87wAD72+Gmb0hks7ZZB1FVR8j7ZjPndw1Yl5ie2 h2myY5rOjgtYzW6Oxjlfb7ZqLUo+xdo/k0hvArXU60XWFguWxYt6vOJ0OJ+FmvGG/R0TA4eK4eWv EG3qdlfEsoWDT6gePG0Qn/yYMUTKJt+tx2EIKN5fM7k3tDijCedJEkVvy2l2YHtbG1+8oh2sbbrd C5cUX5cpCvztepYJHY6a5ZthI9E3VMx8B6Y7cr97XYuou2gnn1A9PqAoPgCKVaTU/ZhckFtPpyHy 9ZhfRO8JM46nz2qlH1S0ISMwFPjmTZTszLTiMzgthpuCJyPpi5CL8L18wuGo/ULymbzILQJJS9wC wsPG9WBDmPq47S5frY9UPB1oj8GSK7aMz4dTUaRp8/2BZ/hKpU+8jDaAe8P752t5WnE5reGGE6N8 Ue7ZijIFETyKz3B6nMQwn+hlwrKjQo+Pj3A9VQlDX6xU4WcUVKhy4rWMTOOiNsMlum99a9ZwTZGH KqD6ut+q7R4rRoqz3joJPg/XQ/NB30OgEqdv6j7Bqm4ZndFr8/C5UdLfuTq/AfR7eYcYy2fZwKut wecOPf0AOHoF6WHgLG4n/bqvz2AxS+M3ao93f6YcfOEPEuOGI0rctvcfpKc3N289TCU9a/z6Jv7e 0n9SRxccixt+0hJCtYygg7N8eTb4PQT+AdIOf8YRMySfAAAAAElFTkSuQmCC .

40The higher risk of Project II can be generalized by requiring that the possible realizations of this project are as follows: the probability of the medium state is reduced by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAE0AAAAQCAIAAADce2XOAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAgJJREFUSEvdVjuSwjAMdfYssAXDCcIJmDRUtNs5JTR7g+1okjIcgYqG5ARw gh2KTe7CSo4t8rEtD5MKVQbLkp70np3o8XiIt7QmXx3EVoik2M2E+HhLjAhqtrsWCaHr4IQGRKu8 8QGv0ihKK/CgxSRtsoadNoUA3oLVWSzirG5/uK2U2okW3Anbfil1d0xGZ1jwDKjKUQNiQlMRFE74 Jygc+MlSH2gXFoPanHvgjiApSLvyhQ0tjes38ra5nMQ2AbFyVt+XmzU60YI7Mdxv8p+jLAsVBFu9 mHejWcLOkq3YH1AqXuM113J2MAHDLJwyzYe47Se5d57PTZorF9Y/UV0pS0fg7RAnHm3P1ZmUUlOV Iwbt+3C2elPC8XG7l8syBk1/nHBomDHOjvbtKVyqtBGr3+fOaMJvmHERT4l7mj+oZvR+VudjrMWK us2+jZb8AlkXJmdvnld8o8nq+2352f4xX8S3e83JridjcsZcm3OEph45qw1aADhB6vHv3+jdrNKv E0Zo8py9BsLqxRaqiwfe38P+ZtbMDXM5UXM6nrqvGq4HrzljXk8iurmD4A+1ZCU+6JxTn8hakLtO HCiswHfleac4qNz5TgjMzF1ITpwvfFsEouRKgn2NEz3ZngSE87jQ10BgmGnL6eAMzP+i23SjCSyA vi4VTyOc6TtblaaiKNb/MXeOq+ccagQAAAAASUVORK5CYIJ= , the probability of the high state is increased by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAA8AAAAQCAIAAABGNLJTAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAKFJREFUKFNj/P//PwPRgIlolSCFBFRvT2dkTN8OVAdhEDTbakKpJ9h+EAO/ 6ju3ruioqQCVQhn4Vd++phMANhnGAIYJEGxLg/jWasJtEDttG0jw9gQrsACCwQBVChYFCqelpVlB 1GIDQNVAsyBqIYbgVguMGTTFMH3YzUby5fb0+FUgt9+ZOBEUwlgBwodAJ4A9i8d4xoFLJ2iOJ5hO UNQDALZgyaCLPmvWAAAAAElFTkSuQmCC , and the probability of the low state is increased by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAA8AAAAQCAIAAABGNLJTAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAANRJREFUKFOVkrERwjAMReXMQihymcBMABVTOC0NG9DROCWMQI+zQSbgUuDs YiTZziUH8RkVvn/207dkWTjnIDuKbJLAFN01QjQdQpOY0bTHsWvHcKPU5z3LICKN6AEMNuGshtOV HMf3q95u5iJUMraXuzI374NOVYmrHeoj70wCgOycUaDYmJSXVku8384EvV5A8IDOYxJnfgfRiLGL t47yF01d2qH37QCUlewHuz6DhR9VnfIGrkMpLJkjNLtat1Ept2VaMc0g58MUzwfwLLJC/PVjP8/4 EGGMT8XKAAAAAElFTkSuQmCC . Accordingly, Project II is characterized by a riskier distribution, which is dominated in the sense of second-order stochastic dominance: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAIgAAAAQCAIAAABC7aArAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAx9JREFUWEftVzt26jAQFVmLSeHDCswKEhqqtHSmhOZ1KelocBm6tKnSBK8g rIDjAnsvvBn9Jcv22ORweOdFlWx95t6Z0R1pdLlc2G+7Pw883B+kX0TogY7A5MvRaJnDPN0xbquy 6WiaVTfyYwDAD1lu4wgmbkXTJwhS1tIOabIrcVx3xORylzA5wge5j8QPHMKWHtq3DozKfeyVYjcN wjLae3e5QBrRmxpqHscmmo3w+iFynGawKa+y1t3ALQKG7qiwmKjU44TOHBAWbiZN08Ts7YRFGnIt 93MGTyHNSPQaOIoRn2YHvF5o3OSWS7XNdikri8n8CdNfd/Cj+vpgL7PIUpKyOCbmD3ylYlnfVhYs js2ifFu8gHMsW9Hsha23qK1DWpVt9unhTUFL4rFNzeHYQLMDXl9QNjWxVhOUgUGBw4Y1A/q8rIC6 bvanMxQR3eFrIS7HyaMdl+p8YuZP/rkXlHu36szi2ePkWJS4NF9u4jnzbAHwhGNymoIvSOjmV0CT MflyvJ68rqImjg00O+H1oFx3o4qMIChLhKoPeFY7ZKimVKqqaFQD1UaIijzMoGpQskB6vM2G66Tc jKMlKG2IZjc8upgBtSAKaRdODGb47h2yB9tpz171WSfGH4VMXBGwgUH3PPHk93LZnE/LhqUlZbYo 5qsIobmiSYQUmgbnGjeLVt+XA3vuf5+kwqOR7dKVBx4XSR6Lx+5P3+rgeg++6gXm6S2YSd8yG4Qb 888TKmAEWrZ+LjA9XIk0B7ImlCRfQP6ojBnHidRLeqDJ8EhkZZaI2pBNRe1QDSuBVfzz5eJDzMta q6sn8z9VYCCiwm/gtYSnB6qwX63CykzxhZWi+XZd27gWIY8mDR45zlaWABp5xeLeVxVcv0JQ8fjd urtCWPKrXgVCLkN3c5rq1p8wwfdQ7QZL213efaF+Ss8Raox4kcmJRHhENH5RtjyuCba/YxoNXVGC ieBD04aHpfZCpqG4NU2L4MDAqOPRfbpoHuiehTl7hTX3hdxtzsy40jDZlGdnBAvJwvjvToT6umDv 7mXjvtn8J4G57yCE0P0FPKa2CEWSUnUAAAAASUVORK5CYIJ= .

41This result can be generalized by observing that the shareholders transfer wealth from the debtholders to themselves for an amount equal to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADgAAAAQCAIAAADMGysSAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAblJREFUSEvVVjtywjAQXecsJgXDCcQJCE0qjiBKc4CU6WjsEjraVGlinwCf IOMi9l2ItPpbcmzBMBNUrXd23/7eLsDl1ldSCDxa3orb80/YdyjQv9M9/ZFRtU2SbcUMtGCMu2KZ LIvujvX0g5oO6xmSvEVtSaWkBWHc5gSUDbeyszX62NFLHAeA6dQ3SDxuJnjF00CJCVpjUY6p3Wy0 g/C1aojL1a1f+upoYvRd8X6k5WEle0PmMya1zeIVNVpA068P2KxTd+bCASDNTjmpm/ZaRhAPOV1v YLfn/JNDlu3EQap+it64hVrtMzUrZ48WMS31kTXReB6YqKACzm3srPhwzNklxihGOH0Xx9jIiHz0 3c8373manS8lvETucvV5VIMXxKitT6QAX9/A68VxcXzu8ETbpl48C9bN5pEUk0VK4Gq/q+lb5jJ4 dQi28OyY2Tjs9OFV1A9LV4NXXB1b2t7SWwPD+zJGnSHWujgBLgFfFkIpoye+8UD9a2QKH/cdSBO3 w+6gPORiOcUxBHPWJ6/o0H5OBphsaI0P9Fmf7D2VJHGAnjVnkvXLkrDWwskl9rXn+q5+D/Pv6Rfm eFzU7BaAlQAAAABJRU5ErkJggk== when they substitute Project II for Project I.

42The features of Project III (i.e., higher risk and lower present value than Project I) can be generalized by requiring that the possible realizations of this project are as follows: the probability of the medium state is reduced by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADQAAAAQCAIAAADWJ8ucAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAWFJREFUSEvNVbFxwzAMpDJLnCLnCZQJ7CobpKNaN97AnRupjEdw5SbSBpkg 5yLiLgwAkgqPlECJ50KocCLw/wAIqtBai7Xa01qFoa6EuK4qiqqDuNh5VFUMRbJzZX3ckY7YyZKH WsjeGmUBJil4cer3Z/vyDBixM6IMeKnL0wYRe9HCNdd9LQ5nDOYoeHH9fftOfYudjLap5nSR7acZ BIzidTOKPHAJgWVo3UqbUPfoS1tdCcPssczQMVmBDYmjp0RigImO3Bh5+ILPiA0lERArpSwtwgTF 9OeEODgGFiR3GlMMIM4kUSBmLpXmmh7M2UEOAgDbffMYWX0i0BZhpqrzzvnOeadze+AtRFd9XLF8 1TT8zmXsAjyUt4vZAHDPh2/n81j/ywDzpBFlN4/rHA4VrrPVMvPq2G1dMLy8hWhlRs2PFMdUCI2b 2S0fJPn7yrpgYZL6ugp74ZbgFfjWrdX+AL/mC+BnLSTpAAAAAElFTkSuQmCC where data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAKEAAAAQCAIAAADxpYgxAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAsRJREFUWEftWDFy4zAMpPwW54pMXiC/wOcmlVp3Upk094Pr3Eil0l2rKk2s F8QvyLiI9BcfQEm0KJEUDNNOJmNWnBGAxQIkACo4VOliIyIhVvnTXNzWD4zATMyf3vPVD2R2o9RF YOYtFHW2CBZZ7bJXJkGQlCAx3vhygwKhZDyAslh7wHXGcEjwAMU6lKBhWh2YC00Q1LdxKzTeMIG3 cRuvDp0KAYoEh91esVlzyBKYamZ7BOEeQ7GWX9+5/bjO1kVUTavXnx8Pv7Dnjzfmkw3nUV57y4LP v8UWXa9S8bxBSTLEMq+iYu0uO+7rxmdtsOuDqW62R9BRqwF3ovY2Vuu3QkQrwrxW7R8el6gx3jCq V539fYm3uTSIVej+zmhZYQ0h5quoPRjalyuwPpUskamdoLNuUMo4ysTyNqnV1RWshrBvvqrKNt7Y fFC6JoHjR4STGCdCgLixXl+WtZHs+UxNZluCgtQbOtaDXErdYY4x4k3oqjSO49CkQwI9HM+HQb7p N9IxLoLhdGpAV2TtyjGfaUtweMHd0T/m7yg3iFSv10/F0IKlpgvdN/3K9e4ge3yi+ncx1pdm2hKc DQJt6RX4RID1+jg1mpWvL2HbnLFPp3+6fklvQsu880k73fpMV+13zfwmxN19uNtXdPt9yaaL29al WV+BKRKceB/jSwvXWvzDwKsJpxcVmF3Cj8/Ru7hM1oWcyLLMMRrzMgOPQzhKbXrKzfPOnSrbuX0r 1DnRRb4T6zOYwiVrCNqLsxplprqnVvO6+gNNUm7PeYVauxRWamj1bWZ4/dgycX0N60swVQRpM9dJ WZ4Spn+3Mld/Oui2BpK2mfoUg9R+TrDpn2mPoJ8cIwvTZEJgxxEB/3l3twHz6alPW4ZQ8JgOnBJN RcV1Ttg4mWLr+LiDbPCrKvphGoDPMsNlkojcNFNxx6Kb3neJwH/J03P8jTFOQwAAAABJRU5ErkJg gk== , the probability of the high state is increased by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADIAAAAQCAIAAADbObvbAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAQdJREFUSEvtlbsRgzAMhnFmyaViAjMBHRukMxNkD7tkhVSpYJFciti7EEuG 42Hwg3NBEVU6n6z/03/CkL7vs/PF5XxIQOTB6mpC6k7X2UnaeVb9vW5R/iiRwE7Sgi36u7HU953f rlreTtIyrfu7seQnr9ArO/FgKVGQQqhQeKu//hJ1tMw0oFxCzlo4lJziwUZibm3F0AnvbUSgUDYw mTaSM8aogYqMUc91GWrChDSWLh5nA38OQIFcwLUIoWxFtWe+17vBLQfdksotNFv5rr4/Yb+UEPBS RUbZIHn1Ihj42O1EiNC07npQHPmwYXNHpzWaTmfr5xMi/39ixFp4fz4RvRKWnhTrB/sPq1bbG1o2 AAAAAElFTkSuQmCC , and the probability of the low state is increased by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADIAAAAQCAIAAADbObvbAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAT5JREFUSEvNVjESgjAQPHiLWji+AF+gla+IpTb+wM4GSn2ClY34An2BQ2Hy l3h3AXQMQgI6wxXMDbm73WyWDIHWGvoXYf8oEaM6WpdlECwvWGQnv92MPf+NFi1yTBOVw0bxZsap nXQg5gBU0MLSOaRoNC1jWO9II/W4T0aDyqQbp2ag/BBVsj2IdG+UQW3GQ3zKbLLgN3byQQv39FK4 lrIjEAAJpFMBgqWizKQyjvDoZFXChR9B5ea0seV7OAHR5ZBzwXE8OWdXN7p2raBXPQdZuQERLRxV bNL0tSb1aiTVrUnuQGR5md2MtwGG4+iWyQ6OBpVM6Ws+LbS+rszQMjyA2E5vYrVVi+RpMJcHEPAR CmEM29Jb5XfSZDtnIECxfuOmRkP6AIXlpdnFUC69XkDh+Qh8ef47lBdQ0M8fmydcw3GA27NhFQAA AABJRU5ErkJggk== , such that data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAKQAAAAQCAIAAAAXjEN1AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA4RJREFUWEftWD1y8jAQlb+zmBQeTkBOQGhcpaUzJTRfR5mOBsrQ0VLRBJ8g PgHjAvsuzq7+LFuyJdvATCZsJYR+9r1dvZXsFUVBnvY3GPj3N2A+USIDbcGOF563iGGQ3qiQl+9e vdddfndCpRs338kJ6aNgMnR3AQsyzu0ccRIn24x2nSPe0htyUradEDEeZ9AlonO5Kg4gypDyH2uL r1YuT33qt1b7ZlakRpjMMQawCtoKjQ2w0TUUrHBNUEaUSLMY4QjagobsqTUEGBhSCQXMiaJI6RsQ au5KdX3WqfU5kts0zIbUAFNNcclYZzesdA0Bi6kkAsnCzWQ8333so/PnVBztYAStLB2HtEdv8HH5 15G8z3xFVbOUBEH5O96k7xCb6phOIqzP9WfvZLXB6nIzsyA1wUwUx7I0iRhTXc1KlwksCLxL0YxP +8n2P7rlL9dRcvzKec0u3Y0Xo9V4vfRp/C9XKMR6Q0ACEpLxixrr/EqC2cs4STNWdj6CkNTHuBOi r0/nAgET6ll3w0KIhmRBm15IrEhNMC+kBI6s0tPR2RzoMoCdfhYHMpc4GnbNr5fKPzQmvHbAMaeS q5Zbmypp8sXkkEsPSBRIx5CyA3ON7vSUTZQ1UWax2LhCNcGsMtyzrDjR1Qq25b5Qmcd/oIxDEqAo +cvv4kzeXCSiIZukHIL07+ZpuPQx62siLk4XO2PS9G1dT4zjglTWDqBZaJc9Wcuq1fVEgg4q4YUc qsob1bQaulJQlM2c6Gp1DkOGFp6YWtWsrn8YbHBeuDsKJlyDuzKAEE8XlDMfdHz1liKZqCV1JkCF TPbNwyD35SlIf8Orh0muMFU33RZU0g5rMKtmvayawPBLL9hOLrnRBS62FAl8DoKdwqKoEQhRKNFh ekJoINjKCYo3K9rrZrV6AuuwwELGsKsBVjv35WqbKikIbvG7Io28dlVwc5ePihfzI0ugndstrwaz msCu8qO76EZXA1ghHXNywJNjEqlpGCXsIou3LqavtMRCBePeuBYydjiVwqC/GQc8QOXjVZ5k/vQf 8PQSnxEAIW12KLQ6TH6ZMH0JsN10mp7YRrpMTy/5pLLuJL+c8KiS8tOJda5pQM/LUq+9eHp1iFLv beoTHw1TnqWbgiXyg0J/Ysprbv81XGY+ap8GXx67/T1280DEyUG7HXWqgs/Bv4QBD9L4l7j6dHMo Az/9vL0TpTz3DwAAAABJRU5ErkJggk== .

43Substituting Project III for Project I increases the shareholders’ expected payoff by a positive amount data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAI8AAAAQCAIAAACgMbtSAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAy9JREFUWEftWL1y4kAMXu5ZTAoPT+A8wYWGipbOlNCkS0lHA+XR0aa65vAT hCdgXGC/C5H2/8fYWvtmyEyy1bLelT6tpE9aRrfbjf2Mx99AsRy9HAIY+en257dZHf146/GeIiP4 1b4TPD5aFrAnnJiD9f559LyvyTqHbdRIhonxT5MshUOPNRZyq2Wc8mxX4fdwIk5Vu4zJLXwXvwSx gJ9wQDbHDinHPimkaTSW0ljhfL/UoCU2GKhN1goajb0LMg6XBmTdoJAAX9QNs1aZAE+ACSfKV8ZV ofPQuh6+4vryPM+MbMdXUpGrOeZu8Ga0XWLWZanY4hvbATIGEw9ueVncWkuX1tzOhFU5mfEiF05w tf73zubTxCKVqjxnZgV+5eJ87KhKlqbmULEt53BXlq5kOmfrLXJ09Kj3m0N+0sU7S8eNBmqTpYIm YztAxkITUBhLVsdddi4rdV4bK72FrI0Dyw/MeakCit4cLleoR+GEywH858mT7az6emFmpfh7UPoj cddXlk6fJhJwsdykM+bpAgsyDi56mBgqluP15G2VdFp6x9hOkBHYwsu0rNPGSg5XpQZzm0peAdGp SqVB9iQrQUsy/4EUoQxa5C35pS/NCkkcKtVQxfHOfhJIOhcCLEu8b5z8DbmFKbA7QoThuBzYm93h R0QH8uXZ8g/odzMPZKkcFpmsh9dRWiRU7RflbJUgRpdzG4CRhEP6o6Rk9XE7sZcBrSwVJAkVd4Lk QZnIjbRkR21QR9tDww8AN/7dYKEHmek/eZukeoAgESLBKgAWrKjsDI0VgdkOkmq2a4zpgtR5+d3q Morl4l2Uqz2tenul438VLQgzkZPjFJqwV+hSkNP9UAt5nkQDVgwX23Ug9b4Mz1gaSBIk3ASspHiI /6lhdUFOh2CeHhDFPFAiio0VcOq9IMjXeXhRA0y9LhCfx+HeUkM7TVOCMQqVWd5iTN0S70d5InwP Dnhc6ofpXVQ689rfW91XEMUm3eKIO3qyoPXIJypytz3c2KHeUokUkZC9Lsocwrjuq02/gftjGKI+ Xqun7Vv9qwv/8S3Y8UO2v+Si8nU2fitvfZ1r74nkE/xoQjGGTBCgAAAAAElFTkSuQmCC and decreases the debtholders’ expected payoff by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAANsAAAAQCAIAAAAQzp1gAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA/9JREFUaEPtWj124jAQlvcsJgWPEzgnSGioaOlMCc12KdPRQBk62lRpFp8g nIDnAvsu7Mj68UiyLcmIJbxFlaJIo/lmRjPfOCHnkGOfkoaR7kPe8ZB1txZwCo8I4DVF0WPtYYHb WOBXx7XZPIrmGWwwJ8qpcvMcPW/KKwKQClzjDieY18eIoV0JrxNS0OO2YOsSIHNqsi6q1X3KZ+ZE nirWCRH76Qls13rdt85wOYoAWOsvsEsBK8xGjEwX+is6ehATjhGfZNKk0S/FG86hrUr6ObY9PJBz CZdJN7N7qVmqGUzkijYRisAWNUrkYe6svjGkBgG/zrjNzx4tu20wGzHWuBBiT3WKdZqmyH5KPHJP 9LUfSw5BHGpR0gt0R3hIM7OqXW7et+n+44VnuGQ4gFmRjybVijnh+8o/n2Q6jtVSyg4TEi926+SQ F30LbWJIjsdTslxRGlEPKEQXEgYLTBNjkR+QbvBTyszkO4qcDIcIySqfwgNHqJvwOl4SzKFWJR0V ktvawkOCZRFZmzWbD5ajt0VcBenxBOTQnAjp4KzD6AkHpLlSifAephwW5ONpogl8+TjvyCyiwxaZ lEWJfTCvGLIVZgPG05HUqLOvrbCxJ8ryRIbjpxF/s9n8fTghmj0b8DpeEsyhdiUdNaqMbQQM8qYE ywgjpSxV1fAhRGbBAkFIQP+CpsqpC0OnxE5OR4uYoH60DrniNG4Ut9SPnrNur/IlOBGvVVDAQYrJ lPtaMJRDGaOxKOkOvDs8OFiaI8vTkRaLePF93pNXW6rpeBNqwqAvQskfIkmxVCWHeWG/xEP1p2Py ZeZLKnG9g9RPx3FL3iRD8Xjiopwgcgc2VqsE7HGDKckCVKjNLJ8sYqqjwVR09ZyEB3Ooq5JOWhFL eAioLEWKlOH1KPXNag9QU2v3R8R2Yjmy7zB+Y0rl6ash/aHs49ke6RjVPNaWy+2IRYNftZ+ikTQq lKey4tpQDnVT0g7WdCvuvLQ2GXIkCt1stVTTWmcG0WkOkBeRMODRvOJeySsTYTmrJW+vmnlIJVe8 0BnZUXRd6S+bzz4ZfdyoHVKbghpGyD5BSCTYnJlqMIRu+zd0RkZFaeRdTnYM5VA3JZ1Uopss4SFJ ZpWRgFhxwa78Soa9eNcav/KTg56ZztNQiWzKGI6ZWHwJA7WqqcdXFZQlkRRWWujwEIVyGD2pUW5t Sa0VromIl5gADjW/l3YSdYuC1vCQziX1d3AP0I69Ri+JbYd6VrAAOnhRmQD3NRU5D7Hyi7/HmVs4 FKuHnEtUotYLRN3H9jrucOj6N9iU+LcaXHLbXTgUm1sDG0HNJrtv3oU6c4LHxp9qAfibNPDpO3bo 439/fmpo/a96/QVktpWrZU1W8wAAAABJRU5ErkJggk== .

44This result can be generalized by observing that the shareholders will prefer Project III over Project I as long as data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAXkAAAAQCAIAAAB87ZhMAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABYNJREFUeF7dWz164jAQFXsWh4KPE5AThDRUtHSmJM12KdPRQBk62q1oFk6Q nICPInAXViNZtmTJ9nhkW17cxHFkzc8bjd6MFXaX13UzmWyu6X282cTq12REFz90LdqXd4yZ44qP 3pJzZvBfA/nT25KKCbrFK1WmHeC6hukxrJCgoGxh6dg01SS5J0SuEUo3sNjbXmPl83MbTGeKXB7G n2174hHw0nz0GDD11IpfYmc/HXbx+ypybfNNPjstB4PlCeRZN0rMyyzeHWCIdd22z4Pn7a1JfZxz pbpRJfXHmVQL1Hv/BV6pkd7Albqrq/DTV4cvfrn3OzRBSs4jkjAgYyPmbFKMtXZnz13yGCcz2jfp zCDbYjbwMFMmIWzygdKVwIZM4qcb62ImWNsd77biT4wzsTrniLByBUYEHi8dIekRany1A1waSg5S 2m34yaKE6B13sDlXUMeIQA3lDJfKMqH+4oaCWDRD7BuDxmado7R/lC/wdOwJ6ifitDcFQpqU8k5E SeVA16ZeYsA5Ez8nrN8UHXmHE2F7ynrCOX0ca6j6ZRozYusBh/dHNtJhTuvhJ20syja1C9d+IAI1 1PXyPRk9NUzYHNNdL+PZCzy3b8zR35er9uD29w+bv+oFHiicPeG/xXJewqUMj1b7zUSTG73O2dva WcyVS+mdM1FOuW0/dvHxU3lReqVBvNholOlxWl/mfCGZmKLU1AbVAY5zeXr1HST8uKHkCLQ96TIh ACI819x+zmw8bLJZA3UaXAAwvxctGgbhfP7h/Rb7xvBONBwzMS65uKO+TfVMhXl7hJgp7Zk1uRzq ia4Gci30zJlIrWG7SfL1afn0NobeXZN4sdHrcJxk8tPyYzRjeUyxiopxdYF7+bzv2SINSU9ZnYSf TDaUCHSmGmsFhUBE9oabvHhymZ5lK2V+WS8/WLJdRquv+xf0n+2beuIh0thuKtPZYDDdUXdImxDl Uq7Jr+pp2czo1p0p1ZT5GnqHg8Psfhf8pkm82DB6GomFc9seRvsV82PSBODAGrhUzpH7H+XqLvy4 du1EIPCcAIg4co1axMlPDQ/FV2CBa6vd4KcQtpt98k3rvGPvKTGnAOt6B6qU7OwPr10tUpbpadiS 49EmIYIQquBHGPMdChf4E6OkvzMxUoDZQr6G9XhkU3q54UY4LcV4VbZdXGarCMyyKyiUqllmVMIQ wGl6qZwzO0janV3FYW+a1e/wQ1kRChFSa7j4GIzWP6ce9Mq14PPNVvPPtdtk+gcvM2XlPn+VqV8s tdHWcAPORDVDNXMI+lfiJd0sPh6pnrPPISoTmKynrUwtj7vkMw36y0ao8CvrDtcMetuEMIgkvIbQ maigKafl4g8MuW23ZLoqROTK1qaqZWhRKEIElYreGhV6W20iNC/rsTOdNmgE77R+q2J3VW7I4cUn l27mRdRk85tXZ/WIiC2OBpxiTQu2h6SEZtuBws8vAk2n9QYR2rf84syqzj7wjUPc1j4lYO+s2hNt drVVEkRkp3ISUOxdjvzNm34wwkFBvJ2JoTVgKv8kXeiKijkweGn+TXgFldio12sBZ3MfjF80nqS0 7Sz8mv/mnTMhBCJdnq/BAew+4e844IebjjSqqvzrwfkakl3Ol9ITe7Qp+4BXQWFMM8h+i1BY+oou jcCaNRToEsAE6QLNEPH/UMEUcSBS6GTYU2qTJALkvnL65EyM+VxfdPOij3ilOvkCV+6sdmc3ZLcl qq15Cx2XEyj/99JutwmO6hODmDCvE7rE+QK8ZmVLxbxD+LPS/ioKVzGB5+uV6nU4oNcwof3QYytk bzhavY+zU7L86BNcqdZV3cAG/26fcGxw8o6mMp3JhQb0Z7XJ/COwOPVEux4BL2V5r2FCw9NjK/4B e/LODrSJgF8AAAAASUVORK5CYIJ= , which entails data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAALAAAAAQCAIAAAA5yWLnAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABAtJREFUaEPVWTty2zAQhXMWWoVGJ2BOILlR5dYdVNJNOpXu3FClNZNCbSo1 IU9gnUDDwtRdlF18SPxEfEh7YhQeil4s3ls87AIguWKrKHE0WrF/xrUJXVkDt2Wel618Db8QNC3L nP7GZ/wfeymM1GfRqSr7/lcwpvizotChMx72oEOIC02EtTXMMFkHU2SnRit0cBJq+B/YgdZ6PYjJ 5LMZAE4TKu8CEaMVxjLMg9QUJUkrJQBjZ6IxZUiZcoPJjoD6jQQBUepngk1mQojUDCG1FKqpEWGO UQNL2JrmEsnajgJg/GClot7cKe3n7uKqIGHvBl3Vu3TX9XGfz+8liGy22K8A88uZPN+nAb58nNHb ZfdCtkUWxg6t7uf5/lhb9oL4RvnPZfcTIEaj05nCQMlkXVAFTo6KI7y7U1Bz0WDiFKJ01qMAaaml 3elKJO2o/NyPqyCMADNgissOth9x9UIGy0UC8jqlStnmZT+e7pRMXfsIvUiao/EMgU0uv6w4lPmp abUlALKKEPoNV+sK9nTVdha+GBXLtjkpCSLJhd6pbcj8oXi/vsdkB+nCjA++R4fzfoz6tXmEbd3j Q0TyYb0nZmpBRf89KvhF18seNhfE5e+f02KmIj9/aGVj+XY9kCeWXTzCuO1qCa0o4I8WIb3EdIXL HAXzu45wrCaWb0lS4BmcGPHBGH6AwGYLEf968zJfEzOqIZgnZeqAqvu3yhMXhCkT4gh+BqsJmxSG Wiz1lawpzuVKjQtIzdVSJysk5J9iAwuBzDIo2iiVy+44PxRk6qQ2BXBcsIRtv1hb7Y0cxgShywS7 DGRnKYz10ZUtolyNIKhugr/m2QO2bRYy87a7p2ZdZBgKo2AEpkNtqFh2XpwnZVsD+zoj76IgIIko yOvX5xMd2naLnelxfbXrb6QrFKN2wLlZMkya02wsY7wMB7o+nvEIBCn69Lxqtm9LjKqVZ1PSYQxG tPXhVFUKmjXSOUFBQMGQMoHpWe1pBXzsJqfuiRxwYKdNoCvFeUSM7Lo9IsVM2xUiy0MINSMvf0H4 PHl2ePhPYzq4gcAJ3hBxJyoB3riEwyOj934uzFWs4vvroPgTnDYWO/Yiie6BXWyJlxGwrHOhOFAr AZKh8MbMMax5TWmZOPG7iehQ5W0tR2VdA7BJ/jY3leNP5/K+j19ZizCrz6Ga8M5YqCO3nZepE7+b SDzU/h5i2hw6ubfs4dF5QegZiNU5fobFewJ209k9GM+BmPV9UmCnCDM3UxeRW6S6wRKgfhtBEIxT ZG2F7S9ufa/b5rXGoxQv892D8Rw4Z3i+jL9tCnTOzGymbiIqfpVUr4cUqOPS29f2Nj/6eEZP+Lrt 55P2UdnvV7fQmTqJQIfuK4P7c0MS1H9BbyBdn2IUkwAAAABJRU5ErkJggk==

45 See Luc Laeven & Ross Levine, Bank Governance, Regulation and Risk Taking, 93 J. Fin. Econ. 259, 263 (2009) (providing a cross-country analysis of bank ownership structures and finding that all the U.S. banks in their representative sample are widely held).

46Michael C. Jensen, A Theory of the Firm: Governance, Residual Claims, and Organizational Forms 144 (2000).

47 See, e.g., Henry T. C. Hu & Jay Lawrence Westbrook, Abolition of the Corporate Duty to Creditors, 107 Colum. L. Rev. 1321, 1351 (2007) (“Managers of healthy companies generally prefer taking less risk than they would if they were acting in the interests of their presumptively diversified shareholders. A shareholder has shares in many companies; a manager has only one job.” (footnote omitted)).

48In economics, the term effort is broadly used to refer to any action the agent takes to advance the principal’s interest. See, e.g., John Roberts, The Modern Firm: Organizational Design for Performance and Growth 126–27 (2004). Conversely, insufficient effort defines any action of the agent that does not advance the principal’s interest.

49Shirking commonly takes place when managers are not fully focused on maximizing corporate profits, as when they exert suboptimal effort in running the business enterprise. The concept of shirking, however, refers “not so much to the numbers of hours spent in the office . . . but rather to the allocation of work time to various tasks.” See Jean Tirole, The Theory of Corporate Finance 16 (2006). For example, managers may find it unpleasant to cut costs by reallocating workers, may not spend enough time supervising their subordinates, or may overcommit themselves to tasks unrelated to the management of the corporation. Id.

50Managers extract private benefits when they exploit delegated authority to obtain benefits to the detriment of shareholders, such as when they divert corporate opportunities, spend corporate money to purchase private jets, recruit top officers from among family and friends, and so forth. See id. at 27.

51 See, e.g., David I. Walker, The Challenge of Improving the Long-Term Focus of Executive Pay, 51 B.C. L. Rev. 435, 446 (2010) (arguing that, as it concerns the problem of risk, the focus “has generally been on the problem of excessive conservatism on the part of risk-averse executives”); Rebecca S. Demsetz et al., Agency Problems and Risk Taking at Banks 1–2 (Fed. Reserve Bank of N.Y., Research Paper No. 9709, 1997), available at http://www.newyorkfed.org/research/staff_reports/research_papers/9709.pdf (“[T]he owner/manager agency problem is characterized by excessively safe behavior on the part of the manager, who pursues his own objectives at the expense of better diversified shareholders.”). Indeed, conservative projects that reduce the variance of the outcome distribution produce the opposite effects of increased risk taking, expropriating wealth from shareholders to the benefit of fixed claimants, including wage-compensated managers. See Jensen & Meckling, supra note 7, at 353.

52 See, e.g., Sanjai Bhagat & Roberta Romano, Essay, Reforming Executive Compensation: Focusing and Committing to the Long-Term, 26 Yale J. on Reg. 359, 361 (2009) (“Until the spate of accounting scandals that began with Enron, compensation in the form of stock and stock options was often emphasized as a key to improved corporate performance . . . .”); Joshua A. Kreinberg, Note, Reaching Beyond Performance Compensation in Attempts to Own the Corporate Executive, 45 Duke L.J. 138, 140–41 (1995) (stating the traditionally dominant view that “performance pay represents the sole acceptable solution” to the problem of managerial effort).

53Executive bonuses in the range of millions of dollars, and even tens of millions of dollars, were common practice in the banking sector before the crisis. See Johnson & Kwak, supra note 1, at 61. In 2009, for example, it emerged that Citigroup owed a single executive a $100 million bonus. Id. Along the same line, in 2000 the average stock option award to CEOs at twenty-seven major U.S. banks was $11.9 million, compared to $4.5 million for CEOs in non-banking corporations. See Mark Watson et al., Moody’s Investors Serv., Don’t Bank on Strong Governance: Observations on Corporate Governance in U.S. Banks 2 (2005), available at http://www.moodys.com/sites/products/AboutMoodysRatingsAttachments/2003700000425158.pdf. In investment banking, this phenomenon was even more pronounced, with “top executive salaries averaging only 2% of annual total [executive] compensation across the whole peer group in recent years.” See Nestor Advisors, Governance in Crisis: A Comparative Case Study of Six U.S. Investment Banks 18 (2009) [hereinafter Nestor Report].

54 See Richard A. DeFusco et al., The Effect of Executive Stock Option Plans on Stockholders and Bondholders, 45 J. Fin. 617, 618 (1990) (“The asymmetric payoffs of call options make it more attractive for managers to undertake risky projects.”).

55Under utility theory—which studies how agents make decisions based on the amount of risk they are willing to take to maximize their monetary income—a simple way to represent risk aversion is to assume that the agent’s marginal utility of wealth is decreasing. That is, risk aversion can be represented through a concave utility function. See Roger B. Myerson, Probability Models for Economic Decisions 83 (2005).

56The risk aversion of Bank Alpha’s manager can be generalized by considering a utility function data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABUAAAAQCAIAAAB2uKNyAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAPFJREFUOE/Fk70RgzAMhWVmIRQ5JoAJfGmoMgIski4NLmEEKprABkzAUYB3 cWQ7mPBjuBxFVBnbn6SnZ4gQAk6Ec4KV6BHPWUhCxqcqdUJIUk/f2L8thjSAIB3Wx1Vs9mGP3oQV gKn1oZU3N7YLyN7iSgjULxUZjahXyeWvovE91zpd93YP2p6DUydlJJPp2MGWgwNougEcmmV06MZa uIoj+oOn0r+6zDXE2SMPrpdtnGZCZLPU8iryvG8VxNmzAPA9YAnjoz5bK0YojhftlIGGqNXHtXHC m/M/9k+brDxaxZe39vejKdnR7BktNsif/7830YyMTNJm7w8AAAAASUVORK5CYIJ= , where data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADAAAAAQCAIAAADfzGvmAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAYJJREFUSEvNVT2WgjAQDpwFLXyeAE/A24Zq2+1C6SU8AJTY2W5Fs3ACPYHP QrhLnAz5hURgn7vPaYzJzOSbme8LAWOMvJOF7wSGY1kIqCt2wa7oRBVNFgRZ8+KSYGQea/M4zlt9 CP+JtYFHNXVs+pOOTnhWNJGa+GNral4/hGcBHeOcCQnKIbQGZ1WtH1BN0VOYH0+fzPSd3zezvWIN HOJMUMQAkgiOJGWZKHp0P9+X7Tpy0yX6+Iyvd0ks9ElKdiJfkFdndsR296u1e7m1JGyyKlVzJE8v 1sFjNvNctkX7M3ZXAvOwX5W52iCZQt6I9ibLhxVNdWNeISAJLK2c3Rq0FmXfVMceRVccjvFmNQ0D JsKMgXKN+MP4UwFWpYyd99bUo/VW3wW9wCTISVRJm9OYsxN+TbX3rF5IavEgmHp26s6tMr7bPwS4 cmvYIaUnAlQXTcpfXC7UD9+xyQhT+UN1T7Rufm7tuQCQHIPuIK/u12+iB20A+9Mk/kePhR/Xv0f2 APLBzsYgV0bzAAAAAElFTkSuQmCC and data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADMAAAAQCAIAAAA0+9DlAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAXFJREFUSEvNlc2VgjAQxxNqUQ8+K8AKuFFFOG4TWwAcsYQ9cVmoYK3A52FD L9lMMiYI+Vqe+pyLkfwz88swM1AhBHlLy96SCqDWko3NkR6bEe81VJRWw4MvKd+mx3id5zWXm2aB Qvmf6J2p9czx0O99sQNelaFr4j/bM9SYhdLOOa0D/04cUN6LsF6712x+sp4ppRBmEQHTXvFQgMWV 8mnCcS3JANe8iNi9w8HDp1UgG2oCfweL6cuGqivNKybj99f5sNsk1/Ky9M9XPj8NIrCuVDA/H07/ Jux2rwouK9q24NcbjlyxskgGiwuBColEG3R8+b11uvYKU2PoThpnbD5P+X4bj2cURStmAWfnQVB2 KmWBsbLZHWxQmR3lxDYbr1kOFSx/FyMhrQHDRYhl5u4Rd2/ayrxrBv+Y8zRgrHvQIQRZjkPdiGDY 3YF5FhrBDrZErvhoQ8UaMj3kphf3pCGZwiWk8uE/Kv6F0rVf9Ocj/gHc4mj2LgGbOQAAAABJRU5E rkJggk== .

57The equity share of Bank Alpha’s manager can be generalized by posing that the manager is paid with data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADAAAAAQCAIAAADfzGvmAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAXNJREFUSEvtlT12gzAMx23OQjLwOIFzgrR7125kTA+QMVuWeEy2rp26FE5Q TsBjCL4LkY2/MYHyGDJUG/6QfrL+ErhtW/RMFj0TDGdZFIjRDd5Q9uccix3Gu0Jeg5ItYs2ZIHJu pC/+JcwsuVHyDKEst9ZgQZxFi9C0AGCF1tFcyi5Ux0oIcYHEBviYBMQDGAsk3ePRZ1Tift4cy3kh iZpFiBdelzCgAijwMVGl4H5/97GnEvbzVaZrtcpulbNf1s00VcWvb6SK6Al9Am5141osTh9p7gYs vq/ZoYcwFkHjrRIpprEbcr+M9hcdjdEjyi/b3tXrCzyhsSl91OU3x0Tbx+sUoYa+14cAjtcNoZK5 gYU3ZU1dkmQ1nYx0os4zUL2vManDIVnaMnVFDe5kFlaXwZodYFDUAii0a8XTQ2V4tPgedF8qCOuA 685Qmrb38ps3mR4nBSXQQzPsX0HAC/WG5jwiUfnh0fzIqX0P///tRzruDvBUn6tMM3gXAAAAAElF TkSuQmCC stocks.

58Formally, this condition can be expressed as follows: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAd8AAAAQCAIAAADYq+LaAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABxhJREFUeF7lWz164joUVbIWkoKPFTArCGmo0tKZkjSvmzIdDZTQ0aaiGVjB sAI+ioG98HT1Y0uWZI5kQ0ziZjxEv+ece3V1JbPzcdbPZrNsdjzjD6/D+lE18LarSm4y5nmyTblO rfGlAMIHUKvPevBAsDQ2Pt5Qzn0iVvWmK2qbo8CaawwArDuz1K0Iagc18fhE14hn/w4s1B0iU1KP 8M5cal/hmWMZTCJQd3KMXK5+AiYKG2eqsVjFEhkqzwfirssVhb+9aM+toaYpiivaiWKft3MnFmrH HY++YLTqt+14wDZ/Jx2g3mn+6+HX/ASUrFdkO354GG/LbXQmq7fP0Q26Z6yFmHA0PLA0gMl2vcx+ Q/TXIjUfvPui230ZZsu1Q7u3159BUHuoqUW9Kd1G2BcNts5r+S2U/2oaqdyS04PEFlQWCljsbaTa 2ckedH9QO/bqae8QzQH7l8bYBVb2FgOIKg7NxYuJWVN2jPBQA5Y0THSHZZwjsYKDqk2mYHBf8jZQ MaLlSsmppkQrAzfjuaDbVILaRA3MsyiYw6ORaZL9+7NQiQg5BpnZQB9U505WwXZMaDPusIyawi8Y QvdlMqo6SjWC8qDQyXgwybKsSOGqRSHeN9vyuwgLOl6vJhIqJ+FM+WxxmuC+GOPCklfomK8m2gYJ qgATnSZq66FyGDV4L+Sac67lG9YFxn6Ec26LhRZDjstsHA+7fvfp4r7l9OeTvb2ayQ+qWPzC/5cN Xy424y+gB8A3ALP+7nDUpTqvb+x9au90O889tv933dxKDUxYt1vMcTs9vPHzNhs3HCMYFi8mfAcJ 5aDAyeLDDpQ8HnpSIO6LXcMQQKhTcMxXFS1tiZThXNRtomjBad6OGqin0/xjmW0W2hlIkJpkXzSX 7LW+xEIpuyEdV8g7U8InN1ieQBa2e/q3Z71nw+tSZjnP+eZpZq7znVWsVJHnxxAf72HXbdnwvdw9 98uu+KlrOnBIL4FCXkB42RqYsO7rc0+5l+34oztkZdzAAcfB4sPkZXFesRHnsiDd17czWXCA4WIC VtUrf5fHB2Sygkn3xWqp7MfaKVqakGMRVbpNEm3LqEGFUQRq2/HTe49ONBpl/y4tlA9aasDvnbfj 9VBnFH3aktif5lO24sWk0rbT917guJDEyZYDaYcPD4NlaoToBt32KsCAUArVjVUOAyQSE/bc4SQQ eqf5uruaMGyNdyfQCCydyV+xHdVe2j1nTUKuqhL3poO9PIt4O0zHH0wFUTQUcfDsvlQ0h3F0e9HK 6K20WbyRbpMpa5aa4DBkoCaCvPXwfBYx9DXZvzMLfdQuU/0rcXxZLF64opSEQomIzmSRH97zBU/b ltd7GOlUnmgqaVPeL/A8pd22HXSTz4+OwYuOBktjwTA6qgGIkBaMidq7c9udjw7DSYdmV8pr3AwW gzPtpYfr6jiaqnixEm1dxpmX4ROerZSE9kv2O9/gJjmVloqWwLA2i/G6RcAsQ4ZQY5WxbK0+NZB0 ecBPkifJbdgAyq2FpIGxf2cW+lhK3+eTp+s5IvVHG40KJ0i7S+FfwrZlu528YRNnvrP2PfbNPcWl qsdj9Z1zt+uity46sg5YjI7qAkICQDDZU4qNl9y9DwR2vq3pzWAxuZDpKhHLXLo5GcKK1nf9txDO wmep1YhyvrP/Uk8iisG3ULRkQdIHpesWANNxWgg1VhmT6waogaRbRIBqK5+0LOtKKPv3Y6GhvDMp itwH3wh+Mh7rsvl4fgqdV3x+WL65lAC23U560pn2hzropo2XeZpABLnJPfhAABCFFxDFs+/gsRoT joKcCk9t9IVfio+o9KBjYQkdkuhoZ8RWZLahQLb5U9bteMQ1RlqbY9eXQ3S1UbR8rE0RdFGlLabG O3bDF1CsdTG0qgbg+1io1AzBEbr6Utz2FG/FVeXS1V7vRR7jR32XUVaz7pDit27UHRODHe/X285t tCZv1HkB8d/XATEx5qCT/NC9aRO34nRAgAPA4h1cca2pmpSEL67Cl8AMaRgai1CFM5W2iTZJt4mi TaAmDHVtahAW6QYbv1OqrDpJ+lal72KhhVOJu+8s7uRaiIQuHd7q9qVWgX8cVXdtk+7h+kTXWkwk y+Ulq9a8E2it1V8ja8U3IqgF950Rv4uVyb85wYqXS+HL0Z0JQEax8V+jFPUUVJUxF/0x6eOKSLZC /cDX1SP7c4rbNtMKTNQ+xbebqEVJgnuui26wPs7vjyCoTdQgnOffnCCF3TI4++30WiELNWMqVnxG iW4trhgMpfHkrxXFntmE3tVhn6zLmt8dkwIfG9YUrJoiOYrgn0BQe6hBKI6ir6Zzvh8LNX2z8SX3 JkO9c4XTR1i5RRkKI2qFiGKOEYD8EExCK1EsVk1oINq6b7WVS51cA6L1rEFfQU0qAhH1otm/AwuV ntl0XP8DRA5WLdZ60ZUAAAAASUVORK5CYIJ= , which implies that data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAPgAAAAQCAIAAAC0pCWzAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABQNJREFUaEPdWjt64jAQVvYsDgUfJyAnCGmo0qYzJTTbbZmOBpfQ0aaiWXyC 5QR8FMF3YWf0sCRrjEe2E9hV5c/oMfPPPw+NEZf/eZxXYzFenW+h4j4VxEj3VVluKGI3WG4lOAvY UDjRTdt7Xg2I3IjksaiAWf4RSY1m/wK2PqoO0Rkuit4kg1L4EGvcuvlXjih/4pwFk8PwSS9kKM45 kTOnToV+qM5QpBd47xBbElgXVU10BkRox32qI0/4wDEzMadMRCakNRzBDCWoD4vnvuJaGnclThAt UoOfYd2ATasQQR4S6n4syIG3G7YKCYWqjppx1IkC1qIqic6NJzBPcSB8oIVtsJ51wxK85iM4wnJt Eex1XqVp6tQRbWmubak9Ru7icJ1SgStybVJiFT89wMsVlMDWvTBxtwn1dVY2Amvn/gC3Kn5/iNeX hLo8+e/Op9H0GV+FD82LgxlF9r5J92u5IQbN4SO5c3mWnpe8vIrFMr964Pl0UNtdH6Hi55MYDu2i fHl6hfqZBQ5xlJEhmW9X48PpbKZQKiSDkTh+Fv4u+ezhKau8o1Tq0YKN8HbA9uAgCdukikwtBhtY iyoQHVA6jAYezwFgORBleJ5JWiExpSnChxayorcYVfPZ42L0a57wjgBTjBUlpJiGCUX2VD5+HoWn EfwGM5UacMiTWhQqXnyK4ctgpDmZz96HUxGAw1M23NyhsVXBbvY4dH1BvX9eX7birTRF3cm9WrAB 3qI9tq5R8t2GE4oIjeOALVHFiF4ZQJ/JUVVSr6fl7F3oqJvM/1z+ABtF+MCzfSVaSVUlBXfTy0VG dvYRSMV8tpuaWo90V3NekS3FFmZq71guRnupRzAwMA4SwAZnFtluuJ0LXm4I9wojViWYOBH+GnwI CQ5DeO2tVxHvbEE+vDHYHsRmogLow8Nk0zZPtgQ2JDr62mqriXDciF9lccGls8kHqI6jm5+EITKg qmjHvZiwEnTl/Of1+hm01vy5kgqT+brkNWQj47gUOXVpBukmeztN5wmCUSlcrHbGaFTE9SMWRqGW AcxIaQg/3dkkVmOQ7hZU2YQDbwS2B+cWAbezit/r/Oxh2iewAdEd02KAW/2Mr6Mg4erhXUb9KGop Kqik3eBUmjUgrCr0sJq6ziSs1iR96x033x2xsIeZh8VEzgvytConqOFrp91Ya5EvF4cUSzN3xBJf lV8y+9H5yGzegwUj4WVh60aM0m4uIF8LLBCdKhhBgHz29oFyFFl2/ebHDfTePCfiIQ1irG6LNKQT UhPyJ4g6GohsJq9u5MUO3n+8ezSvKA4iqSgDjjeWDt4+EDtujHWEe+mWmIbXIryykCiYDPImtuhg VH7t1YIN8LbD1o8Y7Qt0RMmkAhawFlXdLbRdZ9OnhNaYfGS1rWpaobXtRew9QR9Pc5/V8TZHuG0r LSuI6ItK9K7IdpbzMmyht+712ouD1I/87B+gSsrH/kTmre5kwUZ422OrkbBGi2ug2+57LW3IlqbC 3/lgFEU3noy1RC8/C/H2sbM4XXS/ia3W1q1r386NlbycT4vSxwej7hbkwBtAdi/YEnJUPhgpG6Cn dQnfEZYvv1tErIkU0CfO1dD4jYrXHcUhWDNW3RThr75DbEnhXVRv8qeufszaZPiuMbJp//5+/x48 +pNXxpzu6aNPgYi9fFRvQvQv1tBuzw9S3yZS9SAsBL4pj/ar411jG6L6F8qUSjP3M7xOAAAAAElF TkSuQmCC holds.

59This can be generalized by posing that Bank Alpha’s manager is paid with a number, data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADMAAAAQCAIAAAA0+9DlAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAYpJREFUSEvtVj2WgjAQDpwFLHicIN5gt7elwxIPYLkHkHLptrWiWTyBnMBH IdyFTQjJZJLw956FxaZRJ/PzzfB9g17f9+Qtj/+WqDiolyLr8r23z7vNzd6Onne8mWHsaQ6nSuVN Wknbls/2Qgm9tGMI/zUcMOFkvBwqxAzYlwAw4chyTmWbAYqjVFkMV8QL0JRSjMyqLJHxgLlhwUhd k7CAqeasUWhDNetxzGAbedblyfUQlRMkYTz4iuSD4qnvWaCzovu91vFOmrrnA1Gmbtp1zAs+D/Tx lDTlyBhxE/Jzz7LvcxPaTCS3skjPGMtSKYUzjEbCLUWM99CGz3Alp3gszPIUpSUSFlR8ePpZFCC0 vhKR7eaTtqlpFIob9t2dyaCE8TRxTLCLwaBnXwNSQSFkWBdKloaUQbjzejUE7dIms+ntYbaDaoUP d+baXLHK1H6a2FJmIZVSotEccC6AC+0NzmprbNmqLl/XEMCvSpeWpDZ24fwyZPI9soTA1RWfsBXn /f/XWCNM5PMH2njDPwnAD3YAAAAASUVORK5CYIJ= of call options, such that her schedule is data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAEsAAAAQCAIAAADRZRWJAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAgpJREFUSEvdVT12gkAQXj0LWPg8AZ6A2KSyTQelNuks06XRUru0qdIIJwgn 8FEIdyEzu7O7s4AaCHl5capldv73+5hRVVXirmV8191hc0N2WO7mI5A4/duppTFWMd+VVAagdBhJ IiGCbWGCFdtApeBKNxW6aImS7mWQv0xg0qlAeKVOonvcdg/MwKo0GVDf2iN3SKLLY7hWoBPcNkUt qpi/1CFkMzXzMysX1H3ezWnYhoZe3WjmaqzIE6dEIoSvAjJDsqBLpdMf1hRP3mIZnM6E/fJ8criY 5UWDm/40ODxYtvThLqQJlgsPC3oSb/uwFmM28VBDmFUjV2CWw3DGQ+9hdfrERsefyoFsDb/8ESSR +gEUwhjqtYSwSalD/cIWOmDSSM11Krw2qSHR4ceVDqnMRiL+C2IPU7OjpJeYTvpvbQuNS3+d1YCg 4Rfuq03uG8x5k5k1LPIsmPqXUOiYaiMI1yafKwk7kvTjgBgV3moTZe9HvRzULZTs55sKPG53CLYA cpnQjNboEsGpRMCHBOFjlK1fcTGWuxdViEB+065MYzMMqFNYvw5sRK6TY/i8FSqbETY4XTbgVOPa PTK4R5HkTSAXHQKbLaQGFs04NAOshSWQZn3nnaWjy+AUzwGxYdRg24Lt2PZy++68zs0buA28Dy2I f7zl+vVkvOh5dRkj3Pp3Lbf/NP+9/S+AtUYHEpjQIgAAAABJRU5ErkJggk== , where data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAcAAAAQCAIAAABV4/KnAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAGxJREFUKFNj/P//PwMGYMIUAopgF2UAmgAC29IQmtK2gdXemWjtxbANJm2l pQpWC1SYBhWESIFFb0+wYmCwmnAbahpUFG4wTAZmG0wLRBzZZSpqOjCHbEuDGwhyHcRWBpBFMAB3 CCPF4YA9dAAMnHUclk4JYgAAAABJRU5ErkJggk== is the share value that is equal to the state contingent realization of the project minus data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAkAAAAQCAIAAABLKsIUAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAI9JREFUKFNj+A8C29IYsABGoAw2cZAYEy4JkDgWM60m3AaLQuT+355gxZC2 Dc5kAEsjzLTSUgWbr5K/cILVsWu3Yfbd2brqmI6aCpLdV27dgbrl9rVjaQGeyM4CqQSbuX3DLJiJ QB7IEAgX4hCY06DhAHEWSA4YKlA3QgIIxmEAuR4JwMRB+sgNM3zhiU8OANeJdWMhA5u3AAAAAElF TkSuQmCC , and data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAkAAAAQCAIAAABLKsIUAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAHlJREFUKFO1kLEBgCAMBMGxGIh5mMNeRmAEG9zlTcgDWkhnqpBL/hM8APcR 2xeQ+oo50QRybOMhVaCmYFrRWCs00jtjlj3Gk0i6tK5hTAqKXtNkw2Lq6kTbs56FY2U/rnmVbUmz mdFPFbv9M4fjaUZpTBX/w3+u/voGA6KfmMpeXzUAAAAASUVORK5CYIJ= is the strike price of the call option.

60Mathematically, this means that it is always possible to find a value of such that Bank Alpha’s manager prefers Project III to Project I. Indeed, the condition data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAATgAAAAQCAIAAAANlfTSAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABWFJREFUaEPtWjl24kAQbeYs4IDHCfAJsBMiUjIRQuLMoTMSFEJG6ojE6ATm BDwCo7swVb1vkrpBZjQPdTLym+5afy3dRedyuZDHXdms87Jx1E/2l/XocY3Saq5ZoCkI6Tx2oLaY bC3wf1jgjxIzT587z2leJjekl84sgx0lH6F6l7LD/6SLchMrQMJQ7qX7pHa1UJNEkCwubuTauASY pQZ/VdniQbDBzFCb70yrliEEKiqs82pIhqsz+6N47RO+yf3AQ/skhIiPHZzkC9pOtsESx5SQ72d7 8L9wsaNRS/FFAjrLYF18/HTxhHRcPJPuTVzqc1yUzdhmaTlhtKZhQ0cD80EAwF1DNAUhxB8Wfs+B vjKOrA9+wA0wDyV3E1jDDFB7i3PEjFv864ow5UHOT1Jvas4M0qUA4oZ46GspnR2at3Dx5LNrHWed kw7x01MaScs3ChtJkmiJ/oYwbQ5CsPXNvz7J5LVb1dsQcj4NxvSRxf3gh7uvE7JY6u2qS9XDbvS2 Ou7wVHf+/T13JXGPnE+HoZIZ/kqYZFesYb9HT3Xn29XwcDoLEiG6FLFT4kFfuhtfih+nfFygA6q4 gzC+NTouxm55+rFJ9vK5jdmvUdgg/b5SKFueJtCgBSHcb4YmIAQCFdx9GDwZ0aH3yvDNLoron+MP 3GHdD6Uf4G5IN9E2XuIN4Cqg52GXp9PPSX9XCE73SP5zJErmbLcRtowBHIO6pTsTnkWu1CWSKgHx EBh4eZySbfkLsofLaH3Zkql+n/UKUKvjIlRUaTGb9RaDd8iszcIG6b8+DXjKzWYf/TFxEB6sblMQ oj0mCdnxQfrILn+T03L2QXjyhGp3oeXO/TDVRhNls91Y3s58uUAeATQDmL/n8/X7qWe8HRUbE61H Ni/sbaYDE5Zr86Vbiq2UpVXYYN9SdQ+LXqe3IKutp0FwKLlc0Ma4RMCGGOZmx4VpyNIife6TvUKz sEGeur0+rRd5uutv5wTaL942hamo7WoKQtxART9IeB035P2qkeJovR6Bjhz2xa0pFFOWk2GBcTe0 Aa5c2Fmqpy+4MVnhxeu5CGT1r1W0zVKM8VXhUNFqWJQtslw8SFSHz6/SZ/RKTUXAjneqPSk4dLvj lHYwXFZ50NSOdwso2J68BLXolsC/jQ1+P4N2PJ2exvMuGsZtfMNc2RiEOIGqaYVXoNVb/NWPgx0o sYsj9kVFAYCYFskOviuBSzeYlpd89MPQPfqWeQHmmOPnsuXikPCcIUlZcgeRFeJ15+9JWKSWpAc+ qMLa5bu9K51rcJzSznhMMvmq9IuZNbbjuAM2joinLvS+i5cTVhnzmiQNFuTK5iAEArXgKpbNpp+o VZ6mQVWOWUC19KgjmixPl0Bn8ETSGR3SOuy4rzGcif9JyDpS1wUVHkDkBZX+AEV7ITF1CcsffJcm HjyShbyt2U8ENBnxoStcCzDj+NqaWh0XqqJWYjCzxbSU98AGiMe6K0giQ1plAvqkYt2bgxAxnjHm B1RwGCjQGVLU9EkfNqhhokXHHKbYI1RaCD3jGSGh2M8GHsZANWocqG7QQl3r+HWDE0M8zqNsPuvj YsxzypQyLKlxjndc6HgGxYXZB4d21EjsftjQxLphxi7n84XK3hMhNFDZbwairO6FT7DglexcSpVH oqK0enOwLtWkjB3mHPVmLr9klsI5qvxZQ6TawSPfaij+e2zImIkqYqEW8yOEB6ooTtdzxiQedbr0 gCx3RvaI5hFqG7eexOkSxkeUPPnrrkiLFXG5l1lYQr8in0cL2GBsMCdEa3QzQtof5Ydeztp9+N7A RmkBP45pzVWvBdpArdeeLbXWAr9igb8Uc3icGwj0KAAAAABJRU5ErkJggk== is always satisfied when data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAATAAAAAQCAIAAAAeQrQmAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABWpJREFUaEPtWr1y6joQVu6zQAqGJ3CegKShok1nStOko0yXxi7DzL0ztKlo gp/g8AQZF8Hvwt3Vjy3ZlrUS5oScExcZE6/259OutLsSO32f55hGLN5/H32VpqB3lB599EZL4YnT NIr/xXccz/9pvPiwxOGmFm443RReGpxP7InklcBosXsf4xy3nvNR+m0crs4/aJYD8H7xeExjHr/7 2G+cSx1QRF/P7HAqwmsD3A/JL4fRNR+d3//pjNKffwYikC9v7rLSGJzvNvE6GdEZlu9v7Bbo893H 4sFjnFPCbB5vdrmTDARv4vnMTXc5ig4YQZgfkl8OYxg8IiABAHy4L5XZHf9xsyTMXVtoL6s8a3hr mNJqlJSlKyq0bwaFW4yudgWBJwIgezdJp6Yw8KJoMnYrUFOMbqebezDi+YOtxv6W9IgaTyJCRMJC kD5Z4xGB8sTFx3ig7YRRxKMPkl8No9Nq6XIi2GqXFfsmJidVfoTJbXitZmUlc+bwNKydQUFWEsda aSSKhiAJhtocDwcERglQiVR5klY/uhgFZTZhg4wazGKjliibFBLcyImMl240GKWLhnull04uYgqM Lh6mRVV/4CRT1mNxiER+hOvT/HR6bS2R3WlEex2ws5rv92m6X9861w4ywbFgk0lNnb8UC2hdBCV6 tdrID365srbZq4b5L1tOimz9Nkiy8WGEh+LYN7DMnm2J8ij5BRZvF2FybaNoMIopuSIkHTBSMVIW jZJtGnGeIiDLzw90Y8z3Htm2HYxIA8ht2aO5vXbItbOawZMk8KdZF5l7t9zCKXln+ckmD7dTCU6+ fJ7M2dthigWY7wNqs3qgkR1x9VTqCBDZs0j4OF5t9DzTZOur1OD0kMaxj0+zxjWEYOEVtJ65VT0H RuGi2gS5xV2SwgkjSThg3fBVnBoekPjpsBrfjFcs3fb0H8QaCaukDMyOWoLKSlfZWCTrbce666ix omyHwggNKbPdZJuwwGUU1Wa8cuPP/abaZvPlbi7b5xIpe8ArfJyakybsC4guF49/FYy0mWtnYehZ PCAxGxAHXYe39571UwlSjjfftfYxX1Y03bupjsVUNQOP2WMxT0a4szUWeNr2K9WWqwHUNVXUzV5f Z/BV/iaksi6Lqgzgt724NKq+QzxOvRrCfCQJ4b8JRhIgjR4V7gg8f8WAVG48StYxLSJlJxaLTXM3 8GdFndG2V0E3EC2A/OGwui/WkGh3pTWk7dcM5Gbbv/oNBZZXo68zEgjV/sAk1IDMX1bVCkcdA3Qk hIWbibr8D4eRBogs7STOAP1BHI5BQGpuPHtK2erFftyhYh8KTXSaVrHpwUqbceqMmk4C8yu2LchZ I96nr1YZD2/ipD0FpPjK164ye3ljsHWybOl1eNNbtPmqekH6Cx8/ngsjWP5dkKRMUp11YYpxv4n3 MppU25l3lGWx1Hlu4D4MIbMK3AH0LryUpfXBVaHn3Ro31IbrMRxOHYL6X/zN61SFcrmEc0W12y9E pKgcjHOMxrFH4x6POgzrQFj4WyjOAJ8/jPzekgN5Kgh2TKkc+mAkzVjdlGhByUgMroOIcDh4HYpq WlB0Bhrh3e0Xoj1UDoZTm6p13dOjKE/U8HwypzJUEOyqUDn0wHi2nT9X5yj5RTjN6GHhvB2Dp6n8 Lk/7pU+wdo5A5GDWLTrvnuPHcNuHHelEkghCU6shYRzA4p+AHADEPhboR/21T1UMt18U4/aVQ3l/ 47QuoOQncOClsvWQ8XLHHQOi60CSBkIDyWFhHMLYn4AcAsXeiEzW00ajTDapl1l2t/wPOre8W4G9 R/Olh2v5Xiygj4V3IZ7GRA7fPB6hn95A8tpgHMST/geNzyITe7M4ygAAAABJRU5ErkJggk== . For example, it is apparent that when data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADwAAAAQCAIAAADF8ItoAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAYhJREFUSEvtVjFygzAQFHkLccHwAvkFGTdUbt3JpT+RLg2USefWlRvDD3iB RwXiL+ROdyCZkEykFHFmcgUzMLrVsrs6EMNdV63EQiXAeen5XT97uGt2n5Aj0s0+wVpXvRB9tbY3 yb6JeSGG8psJ0YKHFqMRIQdBkTalFLI0dINBUnVs1k2plJITmIUWDjwQFruZiwWyuBwPo1u53aSA DrKci2F4fQoVZVxvtMgy19y86G0pGTwKU2aPti89HEvZaiMEke67K8KijztxXCZ86xQb9tH1vhPZ ZpVbcMzdc1aIU5uvUJDw6i/z3msHKRvDQYDO1UAbx+XgIbgJV0SCpMAV0hYNC71eUMesWKUxHHYP 2Z4uEcfFU9DovOBkmWqni0PanN8WwvE937CXw4F5ANnplg4eS/GVKMtzfiZirQjJLrYaeScp2Dw2 jPvcfADSPuxPtiCu5Oa03c1YCmXthcOpgF/DUcBJlvhkM9QshJidmAFKo3IqH+L/Mx4+0uI6/vC/ R9wL/1rXOzau2REHAULnAAAAAElFTkSuQmCC , the manager always prefers Project III to Project I.

61 See, e.g., Lucian A. Bebchuk & Jesse M. Fried, Paying for Long-Term Performance, 158 U. Pa. L. Rev. 1915, 1916–17 (2010) (describing managerial risk taking in banks as a major cause of the crisis); Douglas W. Diamond & Raghuram G. Rajan, The Credit Crisis: Conjectures About Causes and Remedies, 99 Am. Econ. Rev. (Papers & Proc.) 606, 607–08 (2009) (talking of a “culture of excessive risk taking that had overtaken banks” and relating this culture to the distorted incentives of top bank executives). The popular press also has largely embraced this view of the crisis. See, e.g., Stewart Hamilton, Boards Must Stand Up to Bullying CEOs, Fin. Times (London), Apr. 19, 2010, at 6 (blaming the crisis on excessive risk taking by bank executives). Likewise, regulators have also backed the idea that managerial risk taking largely contributed to the development of the crisis. See, e.g., Press Release, Bd. of Governors of the Fed. Reserve Sys. (Oct. 22, 2009), available at http://www.federalreserve.gov/newsevents/press/bcreg/20091022a.htm (“Compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability . . . .”). Some scholars, however, remain skeptical of this explanation of the causes of the crisis. See Rüdiger Fahlenbrach & René M. Stulz, Bank CEO Incentives and the Credit Crisis 22–23 (Charles A. Dice Ctr. for Research in Fin. Econ., Working Paper No. 2009-13, 2010), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1439859 (arguing that empirical evidence dismisses the role of pay arrangements in inducing risk taking by bank executives).

62 See supra note 38 (defining tail risk).

63 See Shelagh Heffernan, Modern Banking 66 (2005) (stating that interbank claims have risen from $1.5 trillion in 1983 to $11.1 trillion in 2000).

64 See Jean-Charles Rochet & Jean Tirole, Interbank Lending and Systemic Risk, 28 J. Money, Credit & Banking 733, 733 (1996) (discussing interbank transactions and the risks arising therefrom).

65 See Franklin Allen & Douglas Gale, Financial Contagion, 108 J. Pol. Econ. 1, 4 (2000) (showing that the equilibrium of financial contagion depends on the degree of cross-holdings of bank deposits).

66 See Kenneth R. French et al., The Squam Lake Report: Fixing the Financial System 46 (2010) [hereinafter Squam Lake Report].

67 See Markus K. Brunnermeier, Deciphering the Liquidity and Credit Crunch 2007–2008, J. Econ. Persp., Winter 2009, at 77, 96 (arguing that simultaneity issues in the interbank market have led modern banking to resemble an “interwoven network of financial obligations”). The widespread use of credit default swaps (CDS) has played a central role in the increase of simultaneity issues in interbank transactions. See William K. Sjostrom, Jr., The AIG Bailout, 66 Wash. & Lee L. Rev. 943, 950–51 (2009). CDS are a particular type of derivative contract where one party pays periodic fees to a counterparty in exchange for receiving a contingent payment upon a default event (with this payment being typically guaranteed by the posting of a collateral). See, e.g., id. at 947–52 (analyzing the role played by CDS in the collapse of AIG). However, while CDS resemble insurance contracts, a CDS buyer does not need to be exposed to the risk for which it is buying protection. See René M. Stulz, Credit Default Swaps and the Credit Crisis, J. Econ. Persp., Winter 2010, at 73, 74. Therefore, unlike insurance contracts, CDS are heavily traded. See id. Within the net of reciprocal exposures created by the trading of these complex instruments, simultaneity issue may also lead to network (or gridlock) risk “in which multiple trading parties fail to cancel out offsetting positions because of concerns about counterparty credit risk.” See Brunnermeier, supra, at 78.

68 See Duffie, supra note 1, at 2. Securities are the most common collateral in the banking sector. Thus, the posting of more collateral typically takes the form of the requirement of a higher “haircut,” which is “a buffer [debtholders require] for unexpected reductions in the market value of the [collateralized securities].” Id.

69The term fire sale is used to refer to the phenomenon that occurs when a bank is forced to sell a large portion of its assets at a deeply discounted price in order to achieve a quicker sale and promptly satisfy the requests of its creditors (i.e., reduce the risk of default). See Andrei Shleifer & Robert Vishny, Fire Sales in Finance and Macroeconomics, J. Econ. Persp., Winter 2011, at 29, 31–32. When asset correlation is high, price concessions of this type are likely to produce dramatic effects because collective action problems will induce debtholders of other banks holding similar assets to take similar actions. See Squam Lake Report, supra note 66, at 46. This, in turn, will result in a larger number of banks attempting to sell assets at the same time, which will “magnify the original . . . price drop and force more sales” in a perverse spiral. See id. (pointing out that “[t]he size of the . . . price concession depends on how much is being sold, how quickly the firm wants to sell, and how many buyers are available and ready to trade”).

70 See Marc J. Flannery, Lecture, Using Market Information in Prudential Bank Supervision: A Review of the U.S. Empirical Evidence, 30 J. Money, Credit & Banking 273, 278 n.11 (1998) (arguing that increased bank risk taking can create significant negative externalities and systemic risk due to interbank correlation). Viral V. Acharya has extended this argument, claiming that interbank correlation increases individual banks’ incentives for higher risk taking by replicating the debt–equity conflict at a systemic level. See Viral V. Acharya, A Theory of Systemic Risk and Design of Prudential Bank Regulation, 5 J. Fin. Stability 224, 224 (2009) (“The limited liability of banks and the presence of a negative externality of one bank’s failure on the health of other banks give rise to a systemic risk-shifting incentive where all banks undertake correlated investments, thereby increasing economy-wide aggregate risk.”).

71Assuming that Bank Beta’s assets are Project I, the correlation between Bank Alpha and Bank Beta can be modeled by requiring that some mass of the distribution of Project I is shifted from the high and medium states to the low state. Specifically, the probability of the high state is reduced by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABwAAAAQCAIAAACKrYi4AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAPJJREFUOE+tk70RgzAMhWVmIU1GMBPkaFIxApQZJA2UZAoqmCAbUAG7OJJi c5iYv2BVvrP1+b1nWSil4HwNRfSEBCAuHyFAcB5IhPDxLuMR5Qk6k4b2fVSfSwbLvFdK+MnUVvqn fXwYERXD0oOQd9Ke1pxCnZqVOxTcH10uxgY2CXs4lZ/SsPUbTRfZH7pWXi8kgFZJjJNmVZMJUd2/ HeXNZVnYhUrRvFY3iWEuVSvVIW3MC0JNjNyH+Dp3BmAiZ6XrcEChqeQZw4PM3aOGDrrDp7sBQXso hz5I0FQvP99/Qgm61geTBoQrawh3yNfWYR3lBz56bldjJDr4AAAAAElFTkSuQmCC , the probability of the medium state is reduced by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABwAAAAQCAIAAACKrYi4AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAOZJREFUOE9j/P//PwPl4M5E626GMAYG75n5KgwMTJQbCDJBJf/oTG+4UVQy FM1pQO9TA9yeYAU22GrC7f//GakTpqguJcf7wFhhtJ54B09sbEsDS6ZtAwcCyBdQJpZAgaoFexEf YABJAhVDFQINxWIm1DA81qFaAfa+qhYklBnubF2lE+CJ4q/t6YyMGwIgmmaiSiHUMaIClDDd3n2t Bl2j58z//wM2gDWlb8cVjGhhAfY+0P9WE7Zh9TmycqJDAWYoNIURlWRBhuONrEGTTgkWF+QkfiyG gtIIIjKpZCgojUASPAgAAIK4p5FcwKFyAAAAAElFTkSuQmCC , and the probability of the low state is increased by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAB0AAAAQCAIAAABlb+OGAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAQJJREFUOE/dlDESgjAQRQNnAQqHE4QTgA2VRwilHMIDkBI6Wysa4QacgLGA 3CXuhqAyioYijVtlyO7j7Z8BR0pJLJRrgYnIP+a2mZO1prFZzUHwaFbZJDXJwwiW3kWzlO9461ga q566ojvfdNmpLy6lbBjpB6HnkIVcMfQahqfD3nvlahsQSipSJUoNKuIzRTX7OzoNieslVIpSjgWl xQjfB54Ia/D0qcBp9XJmNEy3gC+kEAbg2GZ+3oF4y5cuJql4QQggHtVpqfKEHMRAaI/71SnE1OV+ HRwXSZhwoafLT+SsqZjDQ31t//n5txzeZsmm7l+vft67Q2+457Y2x9J/8g6u6TjC8pWLDwAAAABJ RU5ErkJggk== .

72 This result can be generalized by observing that when Bank Alpha undertakes Project II, the probability of insolvency increases by , which in turn reduces the value of the assets of Bank Beta from data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACYAAAAQCAIAAAD1fJpJAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAPxJREFUSEvtVEEOgyAQXH1L6YHwAvsC7cUf9IbHeukretFjP6IvaF9AehD+ YoFFpU1jUhNqmnQuwjLMsCMB+obzpkc0PKkkDsYaLlRYH2hcQ2+SFU+SeaYTdPKWG8ME1YlbSSKN TFCC9baw89LWd7XSJdXRPDff+gyUwSxTsO3Gc7DDGAiFzigByDuz/coqGZnpxevyejT7JQAhVGQH OO1h0nzHvLM8NeeuzVlV5443xqiNwMbQcIDntPxg/dV5phFEOFknCi5lLIeCcR+7iLTLa9iB5/71 CWw1yK9g+aXOfJv/vwwU+grX5ycs8aHXKNplyX/eJT7f9iVehgc8LW+DOZkh6wAAAABJRU5ErkJg gk== to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAMoAAAAQCAIAAADYone2AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA7dJREFUaEPNWT2WozAM9uxZSApeTkBOkKShmjYdKUOz3ZTTpQnlpJt2K5oJ JxhOkJcicJdZyThgfmyEMey6SfKeI/nT91kSgv0UKzt73jkrvwfnc/D8KXaM/ZA9jLWl+v/EKOaA MAsX4+NPDAUrPF0DVqpLyM22vLiT4DoemdrC9CgmhzAXF+NpIIXiF8OVxJfg7ejw79OtjR9c4mQ6 +zOgmBrCbFyMZ4EWiq7cBZmPu68ntPGCR7vN/AWXoHL1dGyU5Jq5axIUGgjyoQvfJvGbBcV4Kosa rmcT9mBx7Npn5QAtI10VG71XPOjOok/HM6HohhAEQdW78oDqxKUBYoCCVKW0fBpa6GfzB4tjdk89 dzE+XZIspPesvg+9v+6ehRl+Bf6GZKmxaT4UHRCY61bHSU73V3hSqkANgDMfigGHUm9thQKvlQQc 5JU/bmy1tNd45dH65VC0WMnh+a04obNcsdsjl49b9w7tk6HSraGAM+MSCCQwGgjM3S1XItTJ4d31 2Z/UKKTWUIgQa7ggyMsgFF914EVrb3VVCYgglhzOwy5bziis7cXs0lsEsPngz7jVLejLpgCBLZ2F 6+Ff8ih2P49sznqgwz6Ii5ahwaHAQlgLV4e8nlSLT8mpUHNjw8s6kvMRXECRgPBbX4XAYlAN2IDW 1qWvnG4vkhDrTtshVqAgQWCglcIiSGfVV6uze7kli/Z3/+jgtWoDNwFC4UITFi0XtPMMCkUrn3TI q9EFSsyhmjvWtzzSwLtchBYTU1+FqBOBk4UWmZXTWgdac9pxgRUoKBAqa9BFvX30dIJJfMPGFep+ Gm75dkWFMwFC4UIdFj0Xw85DCYWcT6AsQ38h5NVoiEbUGkhHXFPJYRHiE0MS1XJb3bKtxktYtYYC e0SWRevY7xMXjgyLOwTX3Dv/Bi3itTJsIDkOayiwVNG5UHA+IBSlPzCVnELM6SAvbsDWyh/Mu2Er FfvQwaThIl5Kua0hJ1Qg1Luii04OkOXTcK9Ro+6QVlGAozR8Z58d4mpC4KUJETjHb8yoebQHUGl4 MpofW0Wh54LOOC0UkK6kMg1NNB9GWJ57XQPdSLT11mbQeO2/mHuNg1C+glNFyebcS8+FFHrDuRch FPydowEmhS56FWAyyCZq0B4KjUPiq1zikTu22UNhKBry0Smh4L2Xs3vlT9VilY8UYvZDT6NYOdSr 6jTpFgfstIbi30GYj4sBcVVspbEpxNohdXJuJeqdonaiKdW2qVHMAAGgTY1iZJCLv9NC8Rd9E8jg /gxp3wAAAABJRU5ErkJggk== . Hence, the undertaking of Project II by Bank Alpha reduces social welfare by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAIoAAAAQCAIAAABGGHAWAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA1FJREFUWEftVz2WokAQbvYsaMDzBHiC0cTIdDMMNdnMcDITCcds0o1MFk4w nsBHMHAXtqr/GxroBn1vAiuxbaqrv/rtqqCua/Kin2qBXz8V2AsXWqDPPfkuCHY5MMkFrKt0GVCi X3oJWZdpNcQ24bsObIIY29Hng2e3NlTAv0jCblDcOGUJhxmfS7qVJXwlF7BZnmPxXR1tr4CNKD4u mm3gJ6Qk6xNg/WbIUbBdAPncZQWvw2UqjLrWRQXg4bKJ5hsGAK+mK1jIHYXNyT0tJlNheYWPzSiv KYcf74cEuvoFggV8kiRaUE5wjpsKyj2suFXp+yXJPt5E+kQzWJXFYkN35MK1flT//pLtOtTYy+IW qx34lzDRI0iTw0+H6y05nAZrreNdNvAkitTp/FRsoYSYCjoKZ2zuKjD3KHvlu9lhcdyH1GP3b3g4 5MKOAGs0f4agbtIVKHhbzHXvVN93onby6yWmAeBNbclUBPgnplh9iFd5jl2qYQNPovV8cStKFJ/v 3qMNaSrofrGfCtQ9zF700b9u6ppmUbj/qr/ATWphh6B5ttPqCIlcVuzRC4LVZWzo9aQdt567nd4+ 8HUlyq0dCY3ZNA9nEQ2AKr1Gn3sCtWBcfOmZ0IJqUQHdA7GN9kKHZGTl12vhWYaUS7HZB0sbbzdo x6FlEmcXDYvwIP9tYPFIOyVwddEioyEQjM4AgA94JW/h10p7mf4uNvsQYbRL28NVQCToHrCeqDyA 1ysMVaHuSFqRnEodUK4dpxjKFqLpK0kPAEh1s7NvhLMSaLQGpkApGZ6To3x5TQfl1zuGXwjV7bCi XGalltwPV4G7R4vJ/HTwS1vhWXyy8GSewpzTeAoe9fDoYQRAtWjvCY3+YgdGh+hMl9eNdE4DPBiH hS4Ebnz+A2UfL5tS2kQmuKlABxnoG7kegz2o0XaWZ2g48SQcow09P651zmKaYl9sXb9bdy2mJWFv rVpOaKwRT3N8aYPXjDJhaJMD36AK+tyjz5wOljJskSVd7hw/2jhgMFiGBjHvuUcb/XyxjORvqqC5 Rw6fjqJlFLOE6cs2W2g63uLI9sQbnijaUK5xjyg2PKUDKG3ks+PFHOhS4XmeFUfWh7/oKRYIwJVP EfwS+ggL/AdBBYDOKO4iCgAAAABJRU5ErkJggk== .

73To see this, consider an alternative case where at period two Bank Alpha can replace Project I (i.e., the base project) with Project IV (i.e., the correlated project), which generates gross returns equal to $data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABUAAAAQCAIAAAB2uKNyAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAANhJREFUOE/dUsERgyAQhNQCPhwrOEvIPyXoU0vREvLNP1pBrMDxIfaCh4cI E51xxrxyH2C5Pe524VprdiFuF7iG+jN+m3Oet143U51yGx7u0LSelmStVQW4AgDLGlSDosnYetzb Gg5UCrVbCQbZ+MhZrsNaPmr3Z+aXsWmQsWnsA7W7QR3ph5Tu9aYJg0giQWdb9OB9UTwrVkrST5Yd xJJo/RgWPexfFB87PioDjzs+K6Jk60UNVHRfP+eDEzpUMtCfDFzDmWB8cyb6vi6ZNo3/y///tvoU MgN/jNadDheuZgAAAABJRU5ErkJggk== with probability data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABkAAAAQCAIAAABshEP8AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAASJJREFUOE+1UzEWgjAMLZxFGHicAE+Ak6eQURY3RzcXGOUITi7KDXoCXgfo XTBpUqDg4hOzNLTp7/8/wev7XqwU/ko4CPMnrDrzILalZqq63OLGp62sHuRglf0EvyBeByEOL8pn O12RiKToYBcyk9iVLw73BNXMgAw4AdBDJoeV7i0TUwd+6eddFNGD9DBf3TZOU6Tqlk3S5aUpTulw 4COUlLnaM4VqZ9XH4YbKgiixa/UAp+ChJApEfc3j81Gwq3hrppD1jCY5HqCtGCCVdDoW0kw0rW0e E96E8aipUxJ5QKQ3cvAWsDw4MvShXirwfsphtHzorEORoMZGOl3APho0jslgWEGfemzLHI0G66uY TgvNBwYOjQefa/2Sf/off6b3BgaTkIH3vt4LAAAAAElFTkSuQmCC and zero otherwise. Assume again that Bank Alpha and Bank Beta are correlated, with the measure of correlation between the two banks still being 40%. Note that Project IV is riskier than Project I since it has a higher standard deviation (indeed, Project IV has a standard deviation of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAB4AAAAQCAIAAACOWFiFAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAARNJREFUOE/tlLERwjAMRZ3MAhQ5JiATwCBJyQKUDBBK6GipaCAbZIJcCpxd hCXbkhXSpsOVT9J/tr90zgDALLPyZbBIXRo9XsosrLrlZ7T1TJCzrCkvYwwmHIwCvCtjqrfzPN26 YIjZZsd5KlKFmN01VouBNAbJIafYTNEFTGZN1CMu3AaIPfF6XeBx6WrrQ9/cj6s0Nn56VdMN1pjV ZmtuT+/n+Hp0VW4crXu82C/ReOcOt/kZ2m7CaXyb/RVscab+rIcTXJ3XwZlIEHf842e8Tgz2eTIi cZYKEC3LhaZkrZEu/nitekb3UVxpqEyITNDcKMkD1Ouw1KNpJ/1lH7xJ8YIJOkq0ymOiJvv/IXpM F/yevsu+n+R8htROAAAAAElFTkSuQmCC , while Project I has a standard deviation of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAA4AAAAQCAIAAACp9tltAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAJpJREFUKFPNUsEVgCAI1WZpCttHjy3QELaMLtIp24VAUfFmt/4J5MP/8NQA oOawzNGI9ZkanWa4OMqUynY++AwQrLIBLQMkb1SNMcWCyACpAlg0PrU2nsAESRVEEjDe49iM3FOo WZkgZzZ1NjIY6F4p6vJFbjjWuh9WXTdti2hBvYm8gNiZxlY3vAMZaE671/G1WNH/+ANT3+sFGYbY Eb4xHhIAAAAASUVORK5CYIJ= ). However, Project IV has a higher net present value than Project I: i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAKkAAAAQCAIAAADicsjFAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA9VJREFUaEPtWT168jAMNj0L6cDDCegJoEsnVrYwkqUbI1uXMMLGysRScoLm BDwMDXfJJ1m2k9gKsSnPN9BmSUhs6dWrH0ttryxL8Xf9SgaefqXVf0YjA/f3/WX90pPXPCOKs7l+ +iHl2ZwEv6wvt0m6G5Lb1N+RCj8AXfZCzVfXMUaJo7RQv4t0RCrcV/HR7MJVtZ9lCS+qDSTTkoJ7 8YO9Ta+0pDd3w8ZKfAW+88kfCVrgQmZfdmqtLQgAIHc5xIYoI4Id5o0R0qkq7zGlDm8o/WvRV9ka JUN0cZGKZCYz7bKe7acQGUV6WunUyz5g1WbMx2E2n4gjoABngpT9p0xXqgurk+JX1walDUFvJ6pQ ZHMHg1/AO6v8kUCZYpT+GEkAAAkeuE7yG42Fbaw6YwQ5NRItEVZPL/0Md0pJ96EWk1Xeqyfpe/tq RnUjmU1J4DCg7vC890fSkG90sUhC8jAAAOV8nBaG5boiP/NZdQ3K8Qfk/eVzL9LBgc5SdUpfvk+N oMvPhRuEl/XqlL635Dws7y+WwyTqTbZh8RsNqCR4YfAT7Y+EVXoNiW5CFH36ZvUk/gBk0s7Euyq/ tn3jTbkTs662h1XXfx6K7YGaMPB5Hj/JW56cZcGvF1wxfKbqL7Qz4C73AhWjQSSw3C8XQrV2bD8H SPHc2k46+jOQnKsjoWmsg8HP1+4qXyS4k1XahgQFM5c+Og0SbwDZfDXYVZ53+7X+4ksq1DHgzTxA KAYrGTfReVlu6LyP9ZE9fovF6ZvaaH038CGa4CyGjejzAs/yTcS0ABbxEG7xsZjuoyvdfn+xwwOI kiZKcgwtHgPje7/MwzrkgYQ1vPVlYCR6AIBaus2JCaiXwPbkpLmwlekYeIOSzY4+tjogaiZ21EhC DLyQ7103Q30wV3HWztBBDj6ncg+fZEKAGvZY0DL6r9ORo6RujDaE5oTpK8nkMDh8+2YebexAwiq9 hsQ78vyoqHjQXZVTQQwBaprGHr19UWVvdtgSsYqF/EmSYQqu+Q4FIE8+8HDASDR7SK9s+Gt1qSX8 gRaT6zpIOjIFzImM6KsYglIuAAmr9AoSv8gLANBtmA43lcTMlMWqw4OVXAoX+ENgn18NtI2Z20yI dptea0B1U18b6puPxpJKSG3IhK/mPamzdLkY/BpdbqzQUDyRWGBa2fBr9+tGdwJQsxQCtmca5+8i vHpenTX0S98HXRb5ipPG33+agNkZL0hl+JDDi78vkhtM+M8AOtSF+77LZBNyzFTftff6d5164fP9 z/Q+6u4eGNZ9wvyteEQG7v+/nEdk6TFt+gfzBX/gtg38WQAAAABJRU5ErkJggk== . (These features of Project IV—higher risk and higher present value than Project I—can be generalized by requiring that the probability of the medium state is reduced by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAFQAAAAQCAIAAAAHwM/sAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAhZJREFUWEflVj12wjAMVnoW6NDHCcIJeFmYWLs5Iyy9QbcsyRiOwMTS5ARw Ah5Dk7tQyXYckx9b4dEJLfmx/Pn7JEt2cLvd4HWszpYJbACifDsDeHsd4aR0tj3lkZFsiceoBMus dkWjjIMgLskRHwDm5VkRHMNX/5+1SouD2x6tSkMI00p9jFshpBN6iwK9CiEfD1shNI9maRc+OjMY +riQUDIJBVo6C7cRrVRXaeqUjmxdsSHlapwIyTcPPg6zaPoCYMZp29c/B9hE2AB8Vl0X65Vyuhzj BCL94Zs3MF5n33tR5A1A+DFHJw/+LNrALuHsfkYFS05W4NuINfuRAm0SaJUGKwfOzLeDZgcw8L3r auLMDTIgngDU7CoVQqjyfsBc4lUBywKcAm8KpEunydYUMFnzHUSrsYyu5eyJg0Vwnwsrg5P62CCh tnl4M9Sh1jvny+M+1A2AekH6NbGuV3lD4S7zJ7pUGKuu58W7+jH/CM/Xit81VHewjVZcHwMy33HY iQ6Kxz4SXn5753sZfx5ojTrLOD2GTx+AAqw1lMnu3NczAobZMEHrBwCV6Rh4g9BMvjtr6MMqH/nK bB79LTda87TpsZdoBvwy9bY7w6FtW85KkOf8YMf3FpDPYVS8vsr45nfG+dLZwFp8k/KH08xe0LrK 8OcwM8kHVJ6W+KlTH/T/hwzymZgLtSy2gALwclbGMeT56g845U+V27kY+QAAAABJRU5ErkJggk== , the probability of the high state is increased by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABIAAAAQCAIAAACUZLgLAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAMNJREFUOE/Nk7ERgzAMReXMwlExAZkgl4YN0snDpLHLrJAqlVmES4G9iyJZ JBcKDKSKGn9sP+t/A4aIYH8d9iNCrGC9Ncb2yR9lAPgIYJOFCti6SBRdi4G3BcwDUblbGoemrgCq umFnyY/d7ZRTlbH4bDrdB8PDXuE8PcBkMqAuiiXWaoWt5QmVk9JEggmjk9EhosYoF2NMvU+S8zdA 0m1Ozawsd/y6kt5e7pIvec+vaKU0mhS7y3JLQ/NP3+RSwh//gBf0kCjWtOAiOAAAAABJRU5ErkJg gk== , and the probability of the low state is increased by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABEAAAAQCAIAAAB/UwMIAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAOtJREFUOE+dUzEWgjAM/XAWYPBxgnoCdeEUZfUQbiww6hGcXIQbcAIeA+Uu NU1bZfBRMUuTND/5v3mNtNbYaPHGelO+hunKKCq7udmbA3g7IG7OWulmilpxqpXsqVrIlkM+tPZz qOcRnFI1zhW1xTwNeZYASZabqJmK64G7WszcXG6ydSlA7FJKqjEvbBGGR1nh5AJYbkTLzTUE2SVG cCTJ9XS5mjFUSElT5aEflV88g1n0sehVhH0DNfYslizdiX5UoZ15Zl7XD3PAzKQkKWzuKQJ63OYC GpbXsd9cSMPiPn7ewRvcYNEff+EFEDVXlBQCnukAAAAASUVORK5CYIJ= , such that data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAKsAAAAQCAIAAADmhxj4AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA6JJREFUaEPtWD124jAQFnsWSOHHCZwTsDRUtHR2CU06ynQ0pgxd2lQ0a58g nMDPBfZd2NGP9WdZlmQ272WJG8CWZr5vZvTNmMntdkM/1wNH4NcDc/+hjiMwUAFFOpmkRXN8xh8I 8S8iePjW87H5omhSPHd3NkwTXH4V03/EERgYaSLoApYrT+Ksvt3qLE5yWJYn5KO94DYiz8mVJyQz 9AZ+hC9lvd1X+5TZkXdSa8wVPBdO3Uxqq5gHbhGg22gyOh2mvQj9QClxE7EcyZGmQA2/kaa9AtrM 09TXWablX0WpFkQXgGtg6ixJkljYVvKPjcCN8PjggNPAcIRWmiZ/gwhdqZJ1atzY1lEcxYHUqpT+ VLJp7wJ1NV8tqOaW5/SAluwHvtH8+UDr5VRS5Lq6xOIO/ErazX6yXVcoisSW4lCtIeWSr+lyjXaH oGbQHF9PSf7W8oijGTiy0exhOoDQjzCIkRpJ2D6CI3FenMssz+LTWYTJTJNVAO4Q+MIdHb7TVouj VV5Ji59FqIxetlK+oQAu8ye5AJpricSd4nyi4fW+miuKlk/zS1UTJulrtEKaLwhPzJB5mhd1WaSz 3XwPlKw0aQF0mA4i9IDVtU82Gzi2WaK54pdpDCvOaL9dQJh4CfTSZA287d5Yf516d0fk287PuQcK NZVkJoIgtzBWdDt/aIuhlghUJ5ZKs5DGn2GE7n0AMBmxhHKkfUVrdP1wQAPwac3e2fkuT2jPNdKj kLGUXqScAy1VIchx1opX6I7SS3jnqY+barWdYoAdldSxORkHmcKWptvPW45+h77CSGraj9AJD5Xr ULHsTQ+oCoshFhK5EZi2yAfMZ/rQK1Q9p311PXwy2LxK3yxIIZvOgg9SyacEy/2EdZnSSrcjHGZK V8hM+NHtPKFr+TuMmkhdbBUzYvDtQSRNgkW6+aDt/+gwZGlt6l5DAJwIqh2zCOb9F5jYcJvUJ4qe 1jmkWdJxKw67jtWe7RpTN4RDUPhzkM5WLAETlz/T+IEWb8YsfsrzGYiKYmaxSpB9ZBKVBQeOFJlr /5bORluc7csG4edqRz2jeKfUFo3/KwQqAN4GYw4LvvMcoKhQ988KI0JHBdBnJylkgRzNQmFLxcA/ QnYm7krqGBGnZSNiE1CUXKvdR0cnFoORDcbq6X5UBbS96avA0gIP9aZ2Wc84sS4c6tvH2xiOPn7Y 2gl8Ovesb70Q/tbfoHetZ35rRvcB/zgVcJ94/X9W/gIKDXPlck6M/wAAAABJRU5ErkJggk== is positive.) Hence, for Bank Alpha the substitution of Project IV for Project I is always a good decision since Project IV increases the firm’s overall value: i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAKYAAAAQCAIAAAATeZNIAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA1lJREFUaEPtWT1y8jAQNTmLTcFwAnMCSJOKNp0pofk6Sro0poSOloom9gni EzAUse/Ct/JKsn4WLNswEwZUxMayVvve25W0Tu98Pnuv9kwMvD0T2BdWxsDtJS/Wo17ZZilSnM7E XUfK0xkaHq2Ljpa6Dv/bGOsIh4WdtyRiTIRxzn/ncYjU2I+iRI5ibyk/z2d4UA1Am4YVNpZ1mMPE m4Z1fTQMrMxXztfeSTTavPfDaAEsIWO7ChDJaYWR80oSjpQzMT3kinawdI2xgg4IMVVRYaCmnCY5 diYR/KnGIMthqEWKMj91W/nQkg5n+zfAeAkg56ns5vfSLQVgF8lJwk19meRWohqziqCT8to3SpJp 4rJYKSU3mz6nFtaSB/WpvG+VAe72b4aRIhVJqHpIgB0k59SbhBuuwF5efO+9eHDAfZLvwMXvUdvv slNu73/FenWM/40vboz+fDlcBL3JttnWGQxwQ3HyoZnp8u1G9u+AMT9l4SBoBlAcY7hI4mKcamjC TX3fmOJZtjh98AV+OxGHrWHfR0IFR3DdHuBMBlown9OvxXA59/hpjTyijTdlUG8nNUcusJztv4lD meVDC4kRgaP9+2HknqeziZf8zDm1niNARiTRKjvcOkG4pS+e2KNkg8k6/oi84y9yL66SZQiiCNTr BUzqnLm+Cdaf+yns83l8XF04R/v9YZTk031w5dzuz3exBwtC2YIFzwLKB0Jyhwxwt38/jOXCtR6t Bjnnmia5XUyrowjCNX1Rclvd/rCyIlciTwQbSI1rOnSVcQrTkGu/MOK/T0NrEs3P+U9VKITTd7RJ +WBx4pQBvrP9u2EEvT+9nZKYrgABsUNY67zohGvUv3msU6566WGLfEO6Z4svVlnDbsafSaMFy+2d XJwuBSb4KTNbxEZNEAMtgTR91Yd22eBu/9YYwd5pyfUu1rNySXQH6BTWLDBswi19yyKNrlllHWke uJXCjKhplBJOsauUcupTpUbF6Yy5bB9andhFneJgn681XTASAPVHyqcOkuTWGGnCDX15XV77JaN6 wfCH+6x9rtG/I5BFWoMJ9Vdb09FkxsfGWEN4c8nrqJORRlTjdWOv94uMaPtlqtvs6uiHxtgDJO22 xdeoB2Xg9v9WeVAinsft/8NvGc/gVsx3AAAAAElFTkSuQmCC . And, yet, this substitution is inefficient in terms of aggregate wealth since the expected cost Bank Beta bears when Bank Alpha undertakes Project IV exceeds the expected gain of Bank Alpha: i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAALEAAAAQCAIAAADWCwnZAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA8hJREFUaEPtWb126jAMTvospAOHJ6BPULp0YmVLRli6dWTrEsaysTKxlDxB 8wQchibvwpX/ZVskTij33NvioYAjS5/kz5KcxqfTKbqNWwRQBO5u0bhFwInA1ThRrx7ih1X93we8 yOI4Kzw3ioyY/JvOXhMA1A45qnwcpXv7N/dynFdIhM0gMXcVk2RzehH7IYezrJ9yA7D12z6l4Xf1 CPSYGJxOQq2Dns/i8IkwuFL0ZKsntgANAGR8DEbUxtZkMcKMwE5p9WaD4RsPjfpkS0HMNYYfY5QI cH/lwdGjw8OxdvbIcll4vE/hj/RU7P14bB8pwke0adaxCXaKC/oApE8eBrM5HGIoKyQnqjzNK7y/ +Gio7/q5/wV55VLCnDAdpf7KA6NHJa/LjGqN0j3OCWs4NilzbDt1OJzkE+iZpqcPQDKD3nk3Ik3W eT9RZLPoZT5A5bD+OljFsTxWfrGsV8tD/vJoP6g/tuXoHuvSz5OhyKX9lQcWbMAQ5cNdLIYo/Bca HTxNx4cvaI8G89fRIokn62YspLkWDKx1IYbTlQUCcOBVx3I8TMzk4/tpE824Na/rA04U2XK4MYzQ zYveWbWX8LneQYDBNaa/eFuMXucR9JIm8m6gYEm5/SA6ze9Qfm5XGC3LxfFZZtr1RLWDFxqVBwPC yarGetLWQ3vmGGByUnjCFBPj0zqtUi4IgA5QkU2ivatnMP/k1hQ3dNN8B4d9XQLxYQD3wdHJQfKJ Hws8gKEpCMQJ40LFzLwnq9l2yluMw5K6ZAzmmzwS2tk6w9XeysMOE9TOd5HAHp/TSBnrbdRj3+B+ lO6r6TZpun145pgacjIw/yGxIABCHm6Ay2Elw0FYUtx4hsTKc8admjH9IuMTmDSrTd5RTAYuiLIB jzjxQZ4sLyzXCjaKQjh9EsL9lQceJn/7LzEq4FrJF37rekIFmjJ3xnG1PJDuxloTACkFhJhFGy/V WIjZawMYO0isXPDc+wk4XuXijVVilkjEXupRs+yAyo2VTFThtQMFdhO9prfysPPEQqUrVrGT6C8z qtsk2DidG9SJoGCR5hoxBNaOUAAiRcyOr5IQ9SpzMrniIJCGnVmTSXQBkzdZ+5rAvXU7WXQ/oa6n RIvrK9H35o7KA9tz+qVIf6PoMoVUq8jgKRQu0txZDIGeodceVlQJDPYUfs9Evckw9vX7iWBIzi3G o1LjlajNSoDyNhXdn7cata7XQj95Fexuuv+KKwLozolANxhX8Mu/wGX/nNhP8aNDYGOQDavSN6nf EoGr/Q/stwTwB/r5B/twStr/vpxVAAAAAElFTkSuQmCCdata:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAA0AAAAQCAIAAABCwWJuAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAALVJREFUKFO1krERwyAMRSGz+FJlAq2Q3iPAOtQZIVUawwaeIJciZBciCZBR E7uJCs6I9/0/OmwpxRyo0wGGEOGS9+mXBn1LdEJAyNSRqkcQDFMu4opLDjCAxGCTy/Qz5oZCiUDM ia3i+M+h53GROCqSU46Wrm6bkjN2K/LdvLQrgmp+03WG5/vTLr998fyStzK5/Fov5wnbpFjvS5Wk xw3Qt2apNdxlaGNX5VMT1hv7r3ew826+c6jrbB9UCnwAAAAASUVORK5CYIJ= . 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74 See, e.g., Lucian A. Bebchuk & Holger Spamann, Regulating Bankers’ Pay, 98 Geo. L.J. 247, 255 (2010) (limiting the analysis of the problem of managerial risk taking in banks to the undertaking of “actions . . . whose expected effect on the bank’s value is negative”).

75 See generally Charles K. Whitehead, Reframing Financial Regulation, 90 B.U. L. Rev. 1 (2010) (discussing the changes that have intervened in financial markets and the banking sector since the 1970s and arguing that these changes create the need to reform current financial regulation of financial intermediaries).

76 See, e.g., Brunnermeier, supra note 67, at 78.

77 See Strahan, supra note 29, at 17. Loan sales and loan syndication are additional methods that banks use to distribute loans, which exploded in the 1980s with the development of new credit enhancement techniques. See id. at 22–23.

78 See Gary B. Gorton & Nicholas S. Souleles, Special Purpose Vehicles and Securitization, in The Risks of Financial Institutions 560–61 (Mark Carey & René M. Stulz eds., 2006) (providing an overview of the mechanics of securitization). The asset-backed securities generated by the pool of loans are organized into senior and junior tranches having different priority of payment and different ratings. See Martin F. Hellwig, Systemic Risk in the Financial Sector: An Analysis of the Subprime-Mortgage Financial Crisis, 157 De Economist 129, 139 (2009) (Neth.). This guarantees that senior tranches will be negatively affected by portfolio losses only where the “cushion” provided by the junior tranches is not enough to fully absorb these losses. In exchange, the interest portion paid on junior tranches virtually absorbs all the residual cash flows that the loan portfolio generates. See id.

79 See Gary Gorton & Andrew Metrick, Securitized Banking and the Run on Repo, 104 J. Fin. Econ. 425, 425 (2012) (“Securitized-banking activities were central to the operations of firms formerly known as investment banks (e.g. Bear Stearns, Lehman Brothers, Morgan Stanley, and Merrill Lynch), but they also play a role at commercial banks . . . such as Citigroup, J.P. Morgan, and Bank of America.”). Given their traditional involvement in the issuance of loans, commercial banks (and commercial subsidiaries of universal banks) typically served as downstream banks in the securitization process. Stand-alone investment banks (and investment subsidiaries of universal banks) acted both as upstream banks and end investors in this process. And universal banks were involved in all stages of securitization transactions through their commercial and investment subsidiaries.

80By granting access to a larger liquidity platform, the “originate and distribute” model has indeed provided more and cheaper capital to all economic actors. See Margaret M. Blair, Financial Innovation, Leverage, Bubbles and the Distribution of Income, 30 Rev. Banking & Fin. L. 225, 242 (2010) (“[T]his process made a virtual avalanche of credit available to individuals and businesses.”). Political and monetary choices also contributed to the rapid expansion of the liquidity platform. The Federal Reserve’s long-standing policy of low interest rates and government policies that were designed to foster affordable housing helped U.S. banks to offer increasingly cheaper mortgages to their borrowers, with more and more people running to get a piece of the action. See Charles W. Calomiris, Financial Innovation, Regulation, and Reform, 29 Cato J. 65, 67–69 (2009); see also Stiglitz, supra note 1, at 315 n.1 (stating that according to the U.S. Census Bureau over four million Americans became homeowners during the housing rush). As aptly observed by Margaret Blair, however, an excessive supply of liquidity through increased leverage of the banking system might be counterproductive by leading to the exponential growth of systemic risk. See Blair, supra, at 225.

81 Cf. Martin Hellwig, Banks, Markets, and the Allocation of Risks in an Economy, 154 J. Institutional & Theoretical Econ. 328, 330 (1998) (Ger.) (“[A]bstract allocation theory provides the general principle that efficient risk-sharing requires a subdivision of all risks among the agents in the economy according to their respective degrees of risk tolerance.”). Pooling and tranching theoretically provide for larger risk sharing among investors. As compared to a single loan, a security that is backed by a pool of loans diversifies the risk of default across the different loans in the pool. And the issue of multiple tranches of asset-backed securities with different priority amplifies this effect by making the holders of senior tranches virtually immune from the default risk of the underlying loans. See Hellwig, supra note 78, at 141–42.

82 See, e.g., Benjamin J. Keys et al., Financial Regulation and Securitization: Evidence from Subprime Loans, 56 J. Monetary Econ. 700 (2009) (providing empirical evidence that securitization transactions produced lower credit quality).

83 See Hellwig, supra note 78, at 143, 166.

84In principle, similar distortions in risk incentives can be mitigated by structuring the operation as an agency securitization, where the downstream bank (i.e., the seller) retains the equity tranches of the securitization operation. Indeed, the downstream bank should have incentives to select portfolios of better quality when it stands first in line to bear potential losses. Günter Franke & Jan Pieter Krahnen, Default Risk Sharing Between Banks and Markets: The Contribution of Collateralized Debt Obligations, in The Risks of Financial Institutions, supra note 78, at 603, 603–04, 606–07 (arguing that the originating bank’s retention of the “first-loss position” reduces asymmetric information and moral hazard problems affecting loan trading). In practice, however, most securitization operations took the form of principal securitizations, with equity tranches sold to outside investors. See Hellwig, supra note 78, at 145 (“Originating institutions did not, in general, hold the equity tranches of the portfolios that they generated; indeed, as time went on, ever greater portions of equity tranches were sold to outside investors.”).

85 See Hellwig, supra note 78, at 140 (explaining that at a theoretical level securitization should have shifted the funding liquidity risk inherent in the traditional banking model from originators exposed to asset mismatch (i.e., high funding liquidity risk) to investors who have “long investment horizons and therefore do not consider [this risk] to be a risk at all”).

86 Cf. Brunnermeier, supra note 67, at 79–80 (suggesting that banks’ recourse to shorter maturity liabilities was a factor leading to the crisis). The need for less investor monitoring explains the lower cost of short-term debt financing. Indeed, short-term investors can price increases in risk in subsequent loans or, more drastically, refuse a new loan when unwilling to bear increased risk. See Mark J. Flannery, Paper, Debt Maturity and the Deadweight Cost of Leverage: Optimally Financing Banking Firms, 84 Am. Econ. Rev. 320, 321–22 (1994).

87 See Peter Hördahl & Michael R. King, Special Feature, Developments in Repo Markets During the Financial Turmoil, BIS Q. Rev. (Switz.), Dec. 2008, at 37, 45 (observing that U.S. investment banks largely dominated the repo market and used repos to finance about half of their assets). Under a repo agreement, one party (e.g., the investment bank) sells securities to another party (e.g., the repo holder) and promises to buy the securities back at a higher price in the short run, in practice using the securities for collateralized borrowing. For an excellent discussion of the many implications of repo financing and its consequences during the crisis, see Gorton & Metrick, supra note 79.

88In addition to repos, the use of short-term commercial papers—unsecured obligations that are issued for a fixed amount and bear a fixed interest rate—also added to banks’ leverage capacity, providing an important supplement to deposit funding. See Brunnermeier, supra note 67, at 79. In particular, before the crisis, this form of financing was used to finance operations of the special purpose vehicles employed in securitization transactions, typically with the provision of explicit or implicit guarantees by the sponsoring bank. See id. at 80; Strahan, supra note 29, at 26.

89 See Blair, supra note 80, at 277–78 (suggesting that higher leverage poses a prisoner’s dilemma: each bank is better off using more leverage, but all of them may become worse off if the banking system as a whole becomes more leveraged, because this will increase the likelihood of systemic risk).

90In most cases, the settlement of repo agreements was structured to take place overnight, with investment banks rolling over their repo funding on a daily basis. See Report of Anton R. Valukas, Exam’r at 3, In re Lehman Bros. Holdings Inc., 433 B.R. 113 (Bankr. S.D.N.Y. 2010) (No. 08-13555), available at http://jenner.com/lehman/lehman/VOLUME%201.pdf. So banks like Lehman Brothers, for example, “had to borrow tens or hundreds of billions of dollars in [repo] markets each day from counterparties to be able to open for business.” Id.

91 Bear Stearns and Lehman Brothers provide paradigmatic examples of the consequences of the increase in banks’ exposures to funding liquidity risk during the crisis. Both banks had made significant investments in mortgage-backed securities, relying heavily on repurchase agreements to raise the capital for these investments. As a result, when the rate of default on mortgage-backed securities began to increase, both banks suffered huge losses in the investment portfolios they used as collateral to support their funding needs. In response, the banks’ repo creditors required more, and more liquid, collateral. Eventually they denied rollover of existing agreements, essentially playing out a modern version of the classic bank run. See Duffie, supra note 1, at 13–19 (discussing the dynamics underlying the failure of Bear Stearns); Skeel, supra note 1, at 23–28 (discussing the failure of Lehman Brothers).

92 Commission Green Paper on Corporate Governance in Financial Institutions and Remuneration Policies, at 2, COM (2010) 284 final (Feb. 6, 2010) [hereinafter EU Green Paper on Corporate Governance]; see also Jonathan R. Macey, Corporate Governance 2 (2008) (“We care about corporate governance because it affects the real economy.”).

93This view of the crisis has been equally endorsed by academics, policy analysts, and regulators both in the United States and Europe. See, e.g., Fin. Crisis Inquiry Comm’n, The Financial Crisis Inquiry Report, at xviii (2011) [hereinafter FCIC Final Report] (observing that “dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this crisis”); Hamid Mehran et al., Fed. Reserve Bank of N.Y., Staff Report No. 502, Corporate Governance and Banks: What Have We Learned from the Financial Crisis? (2011) (providing an excellent overview of the governance problems that have emerged from the crisis); Nestor Report, supra note 53 (discussing corporate governance ineffectiveness in six major U.S. investment banks); Stiglitz, supra note 1, at 154 (blaming the crisis on “poor corporate governance”); Kevin Dowd, Moral Hazard and the Financial Crisis, 29 Cato J. 141, 153–54 (2009) (arguing that the failure of corporate governance to control managerial moral hazard in banks was a central theme in the crisis); Grant Kirkpatrick, The Corporate Governance Lessons from the Financial Crisis, Fin. Market Trends, Sept. 25, 2009, at 61, 62 (arguing that failures and weaknesses in corporate governance arrangements played a crucial role in the collapse of major financial institutions during the recent credit crisis); Report of the High-Level Grp. on Fin. Supervision in the EU, at 29 (2009) (concluding that corporate governance was “one of the most important failures of the . . . crisis”).It bears emphasis, however, that the attention to bank corporate governance is a recent scholarly trend. Traditionally, law and economics scholars have focused on the governance of non-financial institutions, paying little attention to the special case of bank governance. See Renée Adams, Governance and the Financial Crisis 5 (European Corporate Governance Inst., Finance Working Paper No. 248/2009, 2009), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1398583. Two notable exceptions to this trend are Jonathan R. Macey & Maureen O’Hara, The Corporate Governance of Banks, Econ. Pol’y Rev., Apr. 2003, at 91, and Renée Adams & Hamid Mehran, Is Corporate Governance Different for Bank Holding Companies, Econ. Pol’y Rev., Apr. 2003, at 123. For an empirical study of bank governance prior to the crisis, see Ross Levine, The Corporate Governance of Banks: A Concise Discussion of Concepts and Evidence (World Bank, Policy Research Working Paper No. 3404, 2004), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=625281.

94A recent empirical work by Luc Laeven and Ross Levine constitutes an exception to the lack of scholarly attention to the role played by the interaction of external and internal bank governance in leading to the crisis. See Laeven & Levine, supra note 45. However, that work primarily focuses on assessing whether bank risk taking varies with different types of banks ownership structures (i.e., concentrated or diffused ownership), while this Article attempts to provide a general theory of bank governance mechanisms.

95 See, e.g., Mary L. Schapiro, Chairman, U.S. Sec. & Exch. Comm’n, Address to Transatlantic Corporate Governance Dialogue—2009 Conference (Sept. 17, 2009), available at http://www.sec.gov/news/speech/2009/spch091709mls.htm (“[B]oards of directors did not thoroughly question the decisions of senior management to take on risks. Of equal concern, boards often appeared to misunderstand the gravity of risks taken.”).

96 See, e.g., FCIC Final Report, supra note 93, at 18 (observing that “[a]t too many financial firms, management brushed aside the growing risks to their firms” mostly aided by complacent chief risk officers).

97 See, e.g., id. at 429 (“Managers of many large and midsize financial institutions in the United States and Europe amassed enormous concentrations of highly correlated housing risk on their balance sheets. In doing so they turned a building housing crisis into a subsequent crisis of failing financial institutions.”); Senior Supervisors Grp., Risk Management Lessons from the Global Banking Crisis of 2008, at 4 (2009) (suggesting that the failure of banks’ risk management can be in large part attributed to the unwillingness of bank managers to follow a more conservative investment approach).

98 See Kirkpatrick, supra note 93, at 65–77.

99 See Adolf A. Berle, Jr. & Gardiner C. Means, The Modern Corporation and Private Property (1933). Notably, Berle and Means were the first to suggest that the modern public corporation model with dispersed shareholders may place control over the corporate affairs in the hands of self-perpetuating management. See id. at 86–88.

100 See infra text accompanying notes 207–09 (discussing the U.S. regulators’ subscription to this approach).

101 See supra Part I.A.1.

102 See Triantis & Daniels, supra note 4, at 1077 (observing that the literature on the debtholder–shareholder conflict has developed by assuming away the shareholder–manager conflict). To the extent that it considers the manager–shareholder agency problem, this approach describes risk averse managers as a factor that may mitigate the debt–equity conflict. See Macey & O’Hara, supra note 93, at 91, 98 (suggesting that the risk aversion of managers acts as a “risk-reducing factor” in banks as in other corporations).

103 See John Armour et al., Agency Problems and Legal Strategies, in The Anatomy of Corporate Law 35, 36 (Reinier Kraakman et al. eds., 2d ed. 2009) (describing the agency problem that “involves the conflict between the firm itself—including, particularly, its owners—and the other parties with whom the firm contracts, such as creditors” and observing that “the difficulty lies in assuring that the firm, as agent, does not behave opportunistically”).

104 Cf. Timothy F. Malloy, Regulating by Incentives: Myths, Models, and Micromarkets, 80 Tex. L. Rev. 531, 535 (2002) (discussing the currently dominant representation of the corporation as a monolithic entity and suggesting that regulation should instead take into consideration the fact that corporations are not black boxes).

105 See supra Part I.A.2.

106The pioneering studies on the use of executive compensation to solve the simultaneous agency problems of effort and risk are John & John, supra note 8, at 954–60, which provides a formal model of optimal compensation design and multiple agency problems, and John et al., supra note 9, at 99–121, which provides a formal model of optimal compensation design in the banking sector. For a more recent treatment of the same approach, see Bebchuck & Spamann, supra note 74, at 253, 283–84, which suggests tying bank executive compensation to a security basket representing “a set percentage of the aggregate value of common shares, preferred shares, and all outstanding bonds.”

107 See Acharya & Volpin, supra note 16, at 2 (“[R]ecent literature shows that individual companies can choose governance arrangements beyond what is required by law and regulation . . . .”); Henry Hansmann & Reinier Kraakman, Exit, Voice, and Liability: Legal Dimensions of Organizational Structure 4 (June 2008) (unpublished manuscript), available at http://papers.isnie.org/paper/131.html (“[Legal organizational] forms typically afford[], to the parties forming them, a degree of variation . . . .”); see also Baber & Liang, supra note 4, at 1–2 (“[M]anagers, informed by their understanding of firm-specific governance problems, chose among governance alternatives to construct governance systems. . . . [T]herefore, we observe inter-firm cross-sectional differences in the portfolios of governance procedures and mechanisms that comprise corporate governance systems.”). The thesis of Baber and Liang that managers themselves shape a firm’s internal governance can be reconciled with this Article’s thesis about the governance role of shareholders and debtholders by observing that managers respond to the activism of these investors in choosing specific governance arrangements.

108This is what happened, for example, with independency requirements established by the New York Stock Exchange (NYSE). See N.Y. Stock Exch., Listed Company Manual § 303.A00 (2012), available at http://nysemanual.nyse.com/LCMTools/PlatformViewer.asp?selectednode=chp_1_4&manual=%2Flcm%2Fsections%2Flcm-sections%2F. Before the crisis a large majority of banks’ board members qualified as independent pursuant to these rules. See Nestor Report, supra note 53, at 8. After the crisis, however, several commentators have expressed doubts about the material independence of board members. See Mehran et al., supra note 93, at 11–12 (2011) (“The challenge for supervisors is, irrespective of official independence . . . .”).

109 See generally Philippe Aghion & Patrick Bolton, An Incomplete Contracts Approach to Financial Contracting, 59 Rev. Econ. Stud. 473 (1992) (Swed.).

110 See supra text accompanying notes 49–51 (discussing several ways in which managers’ actions may depart from the pursuit of shareholders’ interests).

111 See Dewatripont & Tirole, supra note 12, at 120 (suggesting that the limited verifiability of the manager’s actions makes the compensation contract insufficient to provide adequate disciplining incentives and requires the provision of additional incentives by means of the “external involvement” of the firm’s investors, i.e., both shareholders and debtholders). For a more detailed discussion of the limits of the optimal compensation approach to bank governance, see infra Part III.C.3.

112In the economics of information, a common agency problem arises when a single agent performs tasks on behalf of multiple principals who have divergent preferences. See B. Douglas Bernheim & Michael D. Whinston, Common Agency, 54 Econometrica 923, 923–24 (1986). Consistent with this paradigm, in the modern corporation managers act as both agent of the shareholders and the debtholders. On the one hand, managers exercise delegated authority over the enterprise on behalf of the shareholders. On the other hand, in this position, they execute the debtholders’ contract with the firm. In my prior work, I have investigated the applicability of the common agency model to the modern corporation at greater length, suggesting that this model provides a better descriptive and normative account of corporate agency problems than the traditional principal–agent paradigm. See Simone M. Sepe, Corporate Agency Problems and Dequity Contracts, 36 J. Corp. L. 113, 124–33 (2010).

113The term multi-dimensional moral hazard is used to refer to moral hazard that involves “effort choices and risk choices at the same time.” See Martin F. Hellwig, A Reconsideration of the Jensen-Meckling Model of Outside Finance, 18 J. Fin. Intermediation 495, 496 (2009) (introducing this concept of moral hazard); see also Biais & Casamatta, supra note 38, at 1293.

114 See Tirole, supra note 49, at 334–35.

115 See Albert O. Hirschman, Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations, and States 3–4 (1970).

116 Id. at 30. Like in Hirschman’s work, in this Article the term voice is used not only to refer to formal powers of decision making, but also to any form of influence (including backroom influence and “jawboning” activities) that shareholders and debtholders may be able to exercise on corporate decisions. In contrast to Hirschman, however, this Article refers to transferability rights, such as sale of stock or other corporate securities, as a form of exit. Although the right to transfer one’s corporate participation to another does not exactly correspond to termination of participation in an organization, what matters for this Article is that transferability rights are a powerful means to influence corporate decisions.

117However, it is important to emphasize that all the firm’s constituencies, including debtholders, benefit to some extent from increased managerial effort, because higher effort increases the likelihood of successful firm performance and the likelihood that the firm will be able to meet its debt obligations. See Triantis & Daniels, supra note 4, at 1078. From this perspective, this section extends the thesis of Triantis and Daniels that exit by a firm’s lenders provides valuable information for disciplining managers’ effort choices, arguing that the interaction between debtholder and shareholder governance produces beneficial effects along the dimension of managers’ risk choices as well.

118 See Jonathan R. Macey, An Economic Analysis of the Various Rationales for Making Shareholders the Exclusive Beneficiaries of Corporate Fiduciary Duties, 21 Stetson L. Rev. 23, 25, 36 (1991).

119 See supra note 111 and accompanying text.

120 See Andrei Shleifer & Robert W. Vishny, Management Entrenchment: The Case of Manager-Specific Investments, 25 J. Fin. Econ. 123, 123–24 (1989) (suggesting that managers may invest in suboptimal projects that require their specific contribution in order to secure their control position).

121Shareholders also have the power to remove the board, although commonly removal must be for cause. See Campbell v. Loew’s, Inc., 134 A.2d 852, 858 (Del. Ch. 1957) (establishing that a director may be removed for cause). In addition, under some statutes, they can directly intervene in the governance of the corporation through the amendment of corporate bylaws. See, e.g., Cal. Corp. Code § 211 (West 1990); Del. Code Ann. tit. 8, § 109(a) (West 2006) (amended 2010); N.Y. Bus. Corp. Law § 601(a) (McKinney 2003). Further, shareholder-initiated proposals are possible under Rule 14(a)-8 of federal proxy rules (i.e., the town meeting rule), which gives shareholders voice in several governance subjects, including executive compensation, board organizational rules, and anti-takeover measures. See 17 C.F.R. § 240.14(a)-8 (2011). For a thorough discussion of shareholder voice, see Luca Enriques, Henry Hansmann & Reinier Kraakman, The Basic Governance Structure: The Interests of Shareholders as a Class, in The Anatomy of Corporate Law, supra note 103, at 55, 55–87.

122 See Armour et al., supra note 103, at 41 & n.26. While transferability of shareholder claims is not provided for in unlisted corporations, buyout agreements and withdrawal rights often grant shareholders of these corporations a contractual right of exit. See id.

123Exit can have a negative impact on share prices, especially when it is exercised by large shareholders. To this extent, exit punishes managers as long as their compensation is equity-based. See Anat R. Admati & Paul Pfleiderer, The “Wall Street Walk” and Shareholder Activism: Exit as a Form of Voice, 22 Rev. Fin. Stud. 2645, 2646 (2009). More drastically, exit in the form of transfer rights “permits the replacement of the current shareholder/principal(s) by a new one that may be more effective in controlling the firm’s management.” See Armour et al., supra note 103, at 41. Hence, “a transfer of control rights, or even the threat of it, can be a highly effective device for disciplining management.” Id.

124 See Hansmann & Kraakman, supra note 107, at 3 (arguing that exit, voice, and liability are complementary organizational means, rather than alternative means as suggested by Hirschman).

125 See supra Part I.A.1.

126 See John & John, supra note 8, at 951.

127 See supra Part I.A.1.

128 See Alan Schwartz, Incomplete Contracts, in The New Palgrave Dictionary of Economics and the Law 277, 277 (Peter Newman ed., 1998) (“A complete contract prescribes payoff-relevant actions for every possible state of the world and the payoffs for these actions.”).

129 See supra Part I.A.1.

130This result can be generalized by distinguishing two cases. See supra note 38 (providing a description of the basic setting of the model that is used to generalize the examples in the text). Consider first the case where the principal and the interest portion to be repaid to the debtholders at are lower than the return of the middle state, i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAFYAAAAQCAIAAAADNR/RAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAnNJREFUWEflVzGWozAMtfcsTApeTkBOkKShop3OKUmzXcp0aaAMXdqtaDac YDhBHkXgLqwk24DHIUDYaWZcyUaW9L8k2/C6rtnPHr9+NnxEP46CKl7xVVx9FV3ZjvNdBtafCF/l G+xCI9T1VXQ9eFFJq3KUkceMFVQW147GbPEqlANbUNGZIU13qAB2w0ZcDJFJCgin+k6fGpcwa92r XV6j2xMLOJzCEZiV6rbQpmEmCWUkhLChYLLbRvDcNyoFJ7xEXl6UNKn+/mHB1lE14oQfENMl+M9F WRZLf402bUE73gZsf8JWGRp9LVsWzHXbzdmpCCC5BE1SAEjz5UIjxZXbHTvfXh8KYeA7Nju1PQl0 vFTxMSFvttAac7aBJ0PqG2SQ83d2qT/CLhIJ8M7c7WKpMpvtjq7PNGRJQVnkQiZCD5OQmcDVdshQ 6kOx344rTgI5wdKioG3BdKsr01xV0MEgNc0D+DKVbOG8uURjFafuJWRFruqeKMjSRLeBSn1nOhq+ DobzTcKSDSVFp5qMAMbzGtjOl4f6vKbZaOMPFdGjgg4Gn9hqOgyyHb8XfuggZNXhSEF1v+kp8nHa 5+Jg19JgtOuzPh2N49DMC/qKfr8E3U4LevRTIpru1L6RpTc86BzohP2mOABbEAbThY4UQGL0FHjd JOKqKR1uwUFiTIVXD5f+fYp4xcRDKiDjEh90guQfzbWMyouuGZ8vs85tqe7Oft3miuy/FCdel523 ychLER8Apqr9JNCQFVb1Lnjy2DBJGPUqeRFon23jbTIqgElKwxSo99knbic5maFsZ3WGscdbOSxP 7Ofvpj7uN+m7oTbw/AP6s20RFAGjogAAAABJRU5ErkJggk== . In this case, the condition that determines the equilibrium interest rate is data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAYQAAAAQCAIAAACZX59lAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABVBJREFUeF7tW7126jAMdu6zQId7eAL6BJSFiZUNxrJ0Y+zGAiNsXTuxXHiC 8gQchoZ34Vq2k9ixE8s/Dek58RRAtmR9liwpIrnf74SO2/Z5Rj6+Xnv8eU2mhIx37GODQ5aiQbZt ZdUOUBrQToe7ouQW4P4QRP5wLZzWSzIdC9fTe/3ajRs4gjqL3utqsFyfHsK7fUxbAkoDiulwl5Xc Btwfggh3RqfDfr76+TDotEiSBbga/SEDYzSZ7w+qN6JOOmGDTUUMmPC8vSEo3UlqtpD/JPw73SwM b0naA4q7mqQZCNApdYd7rrImcEeAYkAk6BxgJtM07X6ck+EmhSc+0s2QTVW+LH72fjrOxYr6g8J7 fpRZUGlUQai40lB/A9GVb4BYXc9bfK6q2i2UNVn+7MC7TaC4ic3ByVDAgC7OXIf7DxljbjEuoIAp lS1HLBTsGMwmDJHR7ftCBk9SeYjmaez48RKSaVDPio1TiumUD2ejPxREvfF0ePmuDWtGb4Wa0g1Z 9vPg47adfU5TITaPqN4v3LHG2YhtC6NdOv2coaOyGjV6gIK5ezQa246cFqX7eSHsJgFcWL6NXb/D nWvaFXe7JfqCYkKEmd5w8xGaRZlNGJxRej0P//adTp0XcXodTEYwU39Q1ztfUxuDTODe68dmmNHf /n0WlS/CXeoHrcTHG/YtUAiFGYZxbR0o9u3ctu/7+XHHIKaDQ2TXWLFwh3t8YwwDxYTIMC8u249E HYVuwtQZab44jAedDRlpVi7JPTdohYU8+oPCsPc0IPWhEfU5ZyWSE/T69yE7YZuA8I89sOALtQXE FY8Qq2WgICRmdjTnt81p0V8OoAiJ0hhfvMMdtBAd9wBQDIjUm1hm99z682GomppNWLxNQx02HBFE hRdWgUqn1/XinYi7EgIVlkDpD7iFc6pCv9lXqmtyXM5ETlO8w4QmzZf354Q9MA7oLSCu+AhCOizx 86CwtyD0smPJ8WFyv7MICa0xzF463DFaUmkig6JDILMb7YzFRUO1xwylwRmV/JrErfB8L3uyf8kI Fc8Hu89zysuerPKw3V2T5hlcv9lv4GOdk0zrRqC7YUQ1dh6sqFWxT7HELwLHJKlWY5lbBSjIuygQ FBQXeqdDAA/u50hevN8hVqu5wz1JMu1YD7AgjAyKCoG/RVRAaXBGJe8msSw8H62GF4V22fMBG5FT QgVn8xbRiLkkQr9CLNqTcXbvSkBshDPylL/eO6K4l5CuAAV3F4WCguJCXXcWoPb/5mU8/wNbntnh LvqTQTHYIxQXFBkCGgFrr7BQl1aNCQtnZHl/5XGkTovZJ/Md2y2yPQjJRNIvJB9SyTROtUYOuXzS v3iVq18ESpakMeXBBeEcrFrR73C3qkgjkCKQGKDIEKyX4m2UMVhR7k4tTauCkjojqFNFG7RV6rzs 06TiMPlaDejjjIzdgqPaEh71x1Jqw14jSwlU6U0WK1/0l2eeUbq2ItSnx5UKixQPtgwU6/mAS3Nw nbFsEi6I6q6QqqU63EEzUXEPBEVFpGR6cqnEejpkgjoTNvabWZvclDTNSu1EoPUJak2PdcuZOrXq 6CNvpCyrpemxhrvrRpx0HJ84b230XrrDnanOFfe6AxwISkDHrt8pID4K8GOFm6W7nqwfHN1IDe2d wT2iOGllqhLbrMnUVxLXU+kucMQZVNjANvcOdwFHPNwDQXEKAqKcJeaMwB1LNpP3ageeLx8Bm9eA j5SNzGkPKNbthqMWvoJVyN9CEAv3QJUGTvfRNndG7O9p+v9QmndGD9CAj9YamtMSUBrYbYd7KcZ+ uDE+ApH/dS98KTozXQwAAAAASUVORK5CYIJ= , which gives data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAFwAAAAQCAIAAAAUF48YAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAldJREFUWEfNVz2WgjAQDnsWsOB5Aj2Ba0PlEbDUxs7SzgZLPYIVjXACPYGP QriLOzMJIRgjhEV3p/ANOH8Z5icfu3+AknAU5dwPUwifk1B5waXyaBQm8MOkUnOIeRSibhKGCRcm I8RVzk2+KvNC/0uN8gO8ej50N9lT4BGl47xw4VWeMd9zF+dkeDwVdiF5PrtxlTwbBhNk0vg6m6LZ 0peIoPTFxdLdDvSKG3iGJ2NS0rnjzFOU1xi7QEHa84ftdYrbFYWL3YatKUltKM9IyV0E2RaCBuXD 4dtBigN+/GdUiW0YJC7dZgGXNZWmrDqdaa7mR4mqrLGuKT5Tb2DdR3a9ozYLNaRF35WRYlhl691N SZE9qTP2OVGbXWgrY6Zuz/jHK7dK0rtE96hjSop0ozOd3OZRJEYgrxX5VTpZqyuJKduDJWECkkJD GYMkhkpPzn6d0VzXZnrVuVoJ18sanvrJC0TYoVteJ5CJ/TcaYU9Vi6y/tD9YkjnsJydviZPaBwN9 Y4xt1sf/kuEXnV9UYNv2af6mTYup2UJPElAptW3Uk1lbM+L2Rmqd9s8zh513Eh+0b+ydFumpBWA1 1uo7Qi4LeZyO+TVe3locph8RdaHaNnLzbarTuv409tEGanHKfIFN0rm3vFyWnsAXptmLuMMZI1bh MAnldEZou1M/s0VQZuzzoXVQnI5sILAJB4dIe8Jyz+HKOA5AYo0YJ40PQ1LWGanrDliW0xMlk4gw 3Qv660qRn7jdR4C6mq0mcL6Nv/IA9bEroGLEdXVGNVYh5xITJWxDdWakH5Upv9eJlPzeAAAAAElF TkSuQmCC . Note that the interest rate is increasing in data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABMAAAAQCAIAAAB7ptM1AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAN5JREFUOE+dUbERgzAMlJklpOCYgEyQVJnCtGmyQbo0pkxGSB+zARPkKGLv 4kgymOPgwOEL7g/96yVLOOdgE5JNLjItOetSiLJG0ZSMnVRnHCrbTVKo65HplIRMtJ1A49LOKLjc Kcl+P/l+N0uGaW11e0r98P0xIUvxa9r8zH+mhFUU47QEyYHEPDWqwBnNHGGhYyfKUUTavoEvLoKc aOHuoceaiet0FdM2/ikA0qxoWhN3437WsGUfvxYMPKuUuCKje6g1G7+QlrEp43ZJuHfccoMqeb+A 7/43BE28CT/vTF2mKs2KNwAAAABJRU5ErkJggk== . Indeed, since in this case the debtholders are paid in full upon realization of the medium state, they are more concerned with a reduction in the probability of realization of the middle state (i.e., ) than they are interested in a marginal increase in the probability of the high state (i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABMAAAAQCAIAAAB7ptM1AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAKlJREFUOE9j/P//PwNZgIksXSBNBHRuT2dkTN8OVIfJIGin1YRST7C70Bn4 dd65dUVHTQWoDZNBwLW3r+kEgG3EZDAwAMMWCLalQULKasJtEDttG0jw9gQrsAAWBihGoNrAKoBK 0tLSrCD6CAGgTqAdEH0Qw4nTB7ITVSPMDEI2/v+PFLbb0+NXgfx6Z+JEUAwSBIjQAToTHFBEWss4 +NItHs8STLc49QIANXMLACoVbvAAAAAASUVORK5CYIJ= ). Consider now the case where the principal and the interest portion to be repaid to the debtholders at are, instead, higher than the return of the middle state, i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAFYAAAAQCAIAAAADNR/RAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAnJJREFUWEflVzGaqjAQDu8srAWfJ8ATqA0VrV0ssdnO0s4GSuloX0Xz5ATL CfwohLvwZiYJJAsoyG6zO1USh8z8/8xkRquua/a75c/vho/ox1FQRStrFVXfRVe2t6x9Brc/WHyX bbgXCqGur1y34IYlnQopQ5cZJ6jMr5rG7OWVSwPdhfTOdGm6QQlQdxtxMUQmKCCc8nf6qTEJu9a8 /MptdAd8AYNTOIJrhXp30YZhJgllyDnvQsFgt4XgOm+UCnaQhG5elLSp/v1l/taWOWIHH+BT4n9x UpbF0lvjnd2FMrz12eGMpWII1M3Y8iwL5jjtx9m58CG4BE1QAEjz5UIhxZPbHSu/ez4TPRY7lT0t yP8qOsVkrbtojdlb3xUu6bK+1AnbwUXyqmHnqjtztouljGy2PzkeU5AFBWWRcxEIJSYhM4HLz+FR TT1I9ttpZdGCjGBqfQS9C9OsykzjVCQmpKakgl7VjmAyL+w3h2isotRJAlbkMu+JgiyNVRnI0Gvb 0fApsCSbmMUbtWlTFdy9rIHtfHmsL2vajb78maKiwkv7MqKpMIh2tCu8wEbIssKRgup+U1vk43zI +RHDMlEgLaUYzyFFuBG0Fb6/BP1xWLBvg6ReLXJKlyy94UNnQyUcNsURmAc3mEp0pAACo7YQyU3M ryo8/SU4kRpd/dXHZfg7lXs7lmAA+hILIi7wQSUI/vG6llHR6Br53My0bil757Bu0yKHm+LEdqnN Jn1NcdSE0h0JFGSJVc4FD4YNk4RRU8mLQIfuNmaTUQ5MUnpOgZzPzAlxko05yhjDmVPRM/MWKMyo 7Z/w6bi/ST8B6SCG/6VdbRGoLGMyAAAAAElFTkSuQmCC . Here, the condition that determines the equilibrium interest rate is data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAUsAAAAQCAIAAAAQ68pJAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABYpJREFUaEPVWzl66joUFm8tJAUfKyArgDRUtOlMCc3tUtKlgTJ0aVPRXLyC ywr4KGL2kneO5EGTrSNZdhw1EUE6068zaIB9i5btZ7N9VvaT/T4pPuYj+vgjS9EHv4HzGAYoPRip J9wHYM+eNJUwY6J/Tljp4LnH/4SHc0GScw9r6jewGAwoPRirD9yHYc8+NJUB+49hS0/H5HUz5v0O W7oejdYp8jM6Bdf5MjmecEjV7oenEW98KqHhhKfDnTDSf0iDCuVXgip+xBYsyXBA8TeTNIMAOoy2 4N6Kq2Vy5/YcjKaq8rYMDqUEH6Sm9faR/JzkFM1OSRx5q1ncKGwgCkpNrz1mqtg4OGJV4FBBTxNG 2qAbUZ/6k6DQpcYiTLQCFwroYpto4JTTkuETVghZmNHt2YGmIXpV2Nj9AnP4/evKpo9SBh9v/vF5 /2rTOoQrakaVkvHXVbABhlqnGjR+Xs2uX40JeP6nWg3Znm0fyjR5P7x8rrJcbJH7d1cRrWqapyKm 5OV/OIP5e7b6fCHXDw3cA0AJSnoujbyIgj4LxjdZiMsb1lxU+jbcAegkSaTlAPhuL+DfHzULM6I9 HQsjvqaYmer0ooFg9wv08Ox2mU0eaFTajMpu0+UcCZgdlezllrn4FAKPNx/7WTH+/veTrZ6LUCXi 1MfKRcrne7cKsFLzte1D1xw7OFDc6twPu2NyfucQQxMQuS1WETZwz25sMqm+T99uKzgRriB2y1SO iGrP+JqivYL00kxg+gV4uJEtPOxmHypvQctYiFbhydnsKFTGj1PWnMTBkS9KzZGPN//fRhOuBBYq vMPLBJIKhCKEINbAQCFIzDNFIkJ4un7YTvFgh2QxQdyC+/2LTZ4fp7njp+vdZMl06EmSxV7k8TU1 lrSsV+FP4mCnbPoJj90vxElbzIb1y5XftGWr29t6x/KojimV189mx5N9Zd9iourvnuRsw6HCPy1h z3fdPY14h3Mgq0AoQiII6UGie1D4cS1kEL43Oi2/v3kuJ1vMCgKUZI/jhwkv0++H0+Rjw3oqN5tN G11TKTjaOM/frQch+iba7hcWD9cihcSyiiWLIzsuioFKLEHty/3E9chey6rNY0E2DhX2LYZg4PLe YzgVgZX5PgeLXaavsFT5p1jiV6fso1G9GXVuNaAQo3tLUEhcoOrAOhN9+swWwTcIkuJlgQ/lweHl ttyMUQ+zlnWiaYHOac8GaOJrqi7pwJVW4xcWD9fihcSviiXKpZ4cSyQMcFe8/xPRM4QkuX1zsdK3 7cX/oo+giGAUKH9zyCFx12CuAYUW3duCQuIC8bAopSDtRqhi0tMVAzlU75ft4oaZombr0ok9a1c4 343E1VRe0lADGWfYPhHW8Ivcwx2n1wFRJV2/fHKHPByI19hEJpJ9sfaUznbi7IDl4iCk+o93GvCL QClqdG48jLreZZWBPoQlYX6IFyLSBpVrEt1I9pRyZRxN5ZABFPPjaGtmVQK9WqXX+oXtQZv7+rP+ YU5xKQeXmLzrfcVnXIxqbw3lpaBfdKtzixtkMcN+Kd6oSMg9unp777gPb3jf1OIm3YSvNSjOFYFq w8VWDk6g4SSMzKvwAs0m2hHtWUsqtqbqKg1wGHE5qdwJyzbCV6u2xwYOSDt8emd5W1g9maesNK8H LpEV0V/nhHt4AChO43Q4oHzXEswjRkhrQNPXnrWkhqEp3cz8Xbqv9nTy/iPNp/llfKJmBoz/3qWD v6T6DI1tkTdDJRkSKE7jgLBUdGpodf6TjEj2/AWaqhYWvzwxSsumwtYJd5sBnQPdRrh+5w4HFKfe 7VFrT8FTyPKJp19kai9newpOTZUB+W/LbL/pOid+yvsxto/uW/0YMndHw1Ip/gQo3SlYUu4H9yHY sx9NJcj+B9ox9+kb4t/jAAAAAElFTkSuQmCC . After some algebraic manipulation, data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAALcAAAAQCAIAAADbFXmeAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAvlJREFUaEPtWTGWmzAQlXMWcMHzCewTeN1slTYdLjdNbrBdGijtIu+l3YrG cIL1CfwoFu6SzEhCCCTE2IZ1eEHVGKSZr8/XjCyxP+M3pjWMloZhKqIW0VqaabiOCvGwep2G2jh8 6/ITpTisiMIokp6M4a2I7lgALeSANGBOphyTsiApIhOwc+6SKyCMKaLIeKyxruHni079SLY+Gwzh B+yj5LGKfPW8RSNLLl93Hn9WfrDAR2N70Aa+v3jM4Qec+sHl6Rv7sWOX1RI9GcMbEbM4BgjdscrT G0M3GjA3O45JWZAUFsDm3NOICxXnjlwBL97Le7p6Own2nE3DY491FT9dgkSp8XVuGvdnH7HwcGHI ViUXPdEQwgg/CqGO1jq6jsgXZL3+zd5yqa3XgPGa1WudVMt9F+A2HqmSKgkijDr79tJzLTkit8sP 0uSnsUD1wCrTmkYvvnaHKrjGNhBlco/9ar2YYah+KAD7YlF8tPtYJ0V01IMH1RGRy42MORieLpUo zZoGcdq25UlblH0BqFuFPj9Tev/YOXepRCU/07iFXJ4FXGmC6HQoP8RwczfBAKiEV+Cqvos6oLbS pmEQ19gr1xsqS9qAngMIhQMexM+sASoDDP+LghZwl8aNMfhXQrrT+VB+qOTM/SQDvOLoe+4RmOn7 0za//6cZEBUH68sd20p6xRlBgCO6HCmvjoh4PNdwqgYHSGdxEHVTa5zO1EDFUdD0Gj9uK+PNwv9+ HgZ9tt9nw3h6mBdQSZGfQ3EC+t+3bL9IliBvOOLUz/wIvMDIxQLVYBrbw3OywZPe6TZQCSSDwywS +IRlnATFjVT4Aez7caxpIMO/2c8p6+Qz7nEmsobKUx7IuyQsOVBxjk88PVAav2XBjqaBT71dkFNu XyihHtBnVklFenW/x39jyeFNSy3igtDesuQotnamIQZ4S5bDFR/2wNrEG1WBD5BFK+SskooQlQRo HwU3uPil43iz/xW/HtkF7rlLw1DO6jva6gIrZa9TqUJ/ATPp7HUIngCuAAAAAElFTkSuQmCC holds. Also here the interest rate is increasing in . However, in this case the debtholders bear losses both under the medium state and the low state. That is, they are are repaid in full only upon realization of the high state. Therefore, the interest rate is decreasing in .

131In both the cases identified supra in note 130, under data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABEAAAAQCAIAAAB/UwMIAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAJ1JREFUOE/FUsERAiEQA2txfF0FdODPKpYK7IM6/AsdUIHDQ66XNQv6OY6T 82NemSEhmcxqZlY7cdipF3nXE6zWNkDRko0c467n0mJJep75+ZhORxha0u2W03QpKS1RitkTnsi/ iXGZOTuDRqtEdnaGPCQAfCBi/gLk1IAB7ecr8UiMFBkFdpvvt1g3GgQ8OUWqGw1C//veNnr+ctcv z8rOl/JzZdcAAAAASUVORK5CYIJ= the undertaking of Project III becomes unprofitable for the shareholders since data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAANYAAAAQCAIAAADlMBbQAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABHRJREFUaEPtWDt26jAQld9anBQ+rMBZAaShok1nSmheR0lHg8vQ0VLRBK8g XgHHRey98Gb0s+SfPvCSkwQ12EbSzL3z0WiCy+VC7uPOwNcx8OfrRN8l3xlABgwumM2DYJ7BvPZD zV+VPgVPafVJhEpNbivPiBRR0kH5+NzxnxkewN5gG19x3NTccBAPjFMSb0v8v/3AVpXbmPApdBY1 DfuAf+FITsMyOv7l+6gr2W5SG0Wo8+4MD3ciobwN0hqoskWvkg56SW0U+sRynWGuugen/lYG7TTk zXcHoMJlVJxkcD3AZ2DbD8IBdbPofOGbH1nlNkmSuN5bc0CukC7ZhQe0uMTFnkxI6YyGRKOS9jop TFGoUpImlbMQm1gFfC60u2K/ygUl99JVhg/ishhNx+ix7Qf8Wr0dyOw5VA6lssjj+gu8JWy96ygL EkX1omxTzMADFFnh84wsN15HYpWud8npVegVRw+dACXkXt2NSjqhZnoQEi722zgvSvqiMxwu3sGr 9zOnfc2TDVZGnbzY7iofsuMu3v5F7sPFKskPb5WoBdUzHp5ZuYO2On9Ajdd+EPzko0fVA6uPM6m/ oDjOq5kHbUb1QaLnxxE3RDZfR1Ny0GUBKzFVznnUgZHNH5aj1SI0Iu2UYaGkrW7gaQ0mGbT2d9sd e+ZRO6N16QOt6ExWZnHhxDb3pheyv7wDu8pAB1EHWhizIKyYnFn5Nis28zXhKQKDjm7RfuhGiIyR 3YRVrEEw2al5y4E8jP3H8CGiPlalx2i/IJBeW+4scoXD1oCWBga9XBynlwvNhs5IeYKyUdJGufZx oYe2zR7mOYD5OIXz77x+AujwQIVYYzezLRIZ8gqj4X5CQQkNDIzfwAVpbtxzbz3vyEqeUWZU+gw8 htnthZfrLSKFksJL+W/jgqWcgWX6UkwXIeqoH/kdulltDnGIOyHxJzK54mZnpaSVSjwqBCIMZJ/T o5Y12SmJoIYImF/HYKN8tILIo2+uFu6fj9K567Gw7h3Ns+sPxc+ti9mHHdReQ/cTeGsXguPXzhJd j5fseMaEF8JJvJwUGBH6AS+VaxjKanMwgQgMiEJzZPcxYaeklUo8KrikbLPME6wOXEctS7uO6Nyi LE8TD4cFSp8eTV0rsGkNCzMWGFq5jmTzlwP+X6WpXZnfKBBuVQiC7zInARdhdHXlBc8ySalP0dY+ 2YZyaKeknRcpUYE1kXJXcivBLKR5smZZlPIg4J7Y2UAdT5OcXSOxBmW5r26RwT2e9qccmh1KL0G0 tlg3QGsQ2vcm6pVKU6Gzv9hukVhJwWXQ7eHGculcaE2Zdt/SuwkqFvaopPe19Mm96vc3ZRzbNUpv Uq+wrHwEWeqYKJugXP/hvqDZrP6tP/Pe/TM8HVDpsLtL95bpLkpb4cGwp6P1KdpEflVfsC3kWhcU Kc8qLK40hrzluCTqpjmdMp+6WGYg7x384ffkE/8NrVc2JIsMdktzB6CMRQ3xM6ZAVwJ6VT29gp8B 8Rui+FUu+A3t8wtU/gd8ZIDzKhOOfQAAAABJRU5ErkJggk== .

132 See Charles B. Cadsby et al., Pooling, Separating, and Semiseparating Equilibria in Financial Markets: Some Experimental Evidence, 3 Rev. Fin. Stud. 315, 318 (1990) (“Consider a situation in which a firm’s management has better information than do potential investors concerning . . . the value of the firm’s assets . . . . Investors take into account the presence of less valuable firms in the market when deciding how much to offer for newly issued securities.”). See generally George A. Akerlof, The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, 84 Q.J. Econ. 488 (1970) (discussing the concept of pooling equilibrium).

133Cross-subsidization is the problem that arises when good firms (i.e., firms that undertake projects like Project I) receive worse terms (i.e., higher interest rates) from the market than they would if their nature were known; whereas bad firms (i.e., firms that undertake projects like Project III) receive far better terms. See Tirole, supra note 49, at 252.

134Credit rationing describes a market condition where creditors offer less aggregate credit, with the consequence that good business projects might risk going unfunded. See generally Joseph E. Stiglitz & Andrew Weiss, Credit Rationing in Markets with Imperfect Information, 71 Am. Econ. Rev. 393 (1981) (modeling credit rationing in loan market equilibrium).

135 See supra text accompanying notes 36–38.

136In economics of information, signaling is used in the context of asymmetric information when the agent has private information that she wants to reveal to the principal in order to obtain better contractual terms. See generally Michael Spence, Job Market Signaling, 87 Q.J. Econ. 355 (1973) (defining and examining the characteristics of market signaling). Since a credible signal is always costly to the agent, it implements what in agency theory is termed a bonding mechanism: i.e., a mechanism that protects the principal by imposing penalties on the agent for a shortfall in performance. See Jensen & Meckling, supra note 7, at 308.

137 See generally Jeffrey S. Banks & Joel Sobel, Equilibrium Selection in Signaling Games, 55 Econometrica 647 (1987).

138 See, e.g., Prod. Res. Grp., L.L.C. v. NCT Grp., Inc., 863 A.2d 772, 787 (Del. Ch. 2004) (“It is presumed that creditors are capable of protecting themselves through the contractual agreements that govern their relationships with firms.”). There are, however, some laws that are designed to protect creditors’ interests under specific circumstances, including federal securities laws that impose mandatory disclosure duties on the debtor, rules on capital regulation, fraudulent conveyance law, and the equitable powers of “piercing the corporate veil.” See generally Robert Charles Clark, Corporate Law § 2.4, at 71–74 (1986). From a contractarian perspective, this minimum set of “creditor-protecting rules” can be seen as a mandatory contract that binds parties even when they have not bargained for such protections. See id. § 2.1, at 37.

139It is important to emphasize here that while this Article examines banks as debtors, the general theory of debtholder governance is based on the benchmark of banks’ conduct as creditors of non-banking firms. See Triantis & Daniels, supra note 4, at 1080–81; Tung, supra note 4, at 125–26. More recent economic studies, however, have suggested that bondholders also engage in active governance, mostly by bargaining for risk-event covenants. See K.J. Martijn Cremers et al., Governance Mechanisms and Bond Prices, 20 Rev. Fin. Stud. 1359, 1362 (2007).

140 See Tung, supra note 4, at 13540 (providing a detailed description of the various types of debt covenants); see also Smith & Warner, supra note 35, at 125–46 (examining the ways in which bond covenants are written to control conflicts between stockholders and debtholders).

141 See Triantis & Daniels, supra note 4, at 1084 (describing the several forms that exit in the form of a right of withdrawal can take).

142Debt covenants are often designed to trigger further governance actions upon violation. A typical scenario might feature debtholders threatening to exit unless they receive monetary concessions. Thus, renegotiation is often an agreed upon and standard feature of debt agreements. See Greg Nini et al., Creditor Control Rights, Corporate Governance, and Firm Value, 25 Rev. Fin. Stud. 1713, 1720 (2012); see also Michael R. Roberts & Amir Sufi, Renegotiation of Financial Contracts: Evidence from Private Credit Agreements, 93 J. Fin. Econ. 159, 160 (2009) (reporting that more than 90% of private debt with stated maturity exceeding one year is renegotiated).

143 See supra Part II.B.1.

144 See George A. Akerlof & Paul M. Romer, Looting: The Economic Underworld of Bankruptcy for Profit, Brookings Papers on Econ. Activity, no. 2, 1993, at 1, 10 (observing that bank managers may invest in projects so risky as to be sure failures as long as they can divert money for personal use through these projects).

145 See Bebchuk & Spamann, supra note 74, at 264.

146Thus, in the example in Part I.A.2 it might be initially optimal for Bank Alpha’s shareholders to compensate the manager with a stock option plan where the wedge of the manager’s additional leverage is given by data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADcAAAAQCAIAAAA9EHCfAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAW9JREFUSEvtVjF2wyAMxT2LT0GPkCVT1m5kzAV6CLJm69opS/EJ2hN0qnMX KgECQTAhHfrc98pgP/OR+JK+9DxYa8Xq18PqGSLByHLa76f1MoaKW6MiP6ln3GG7bmfW0h9RhuB7 3umCmv0y6hGpheMItkbBA8gwmkgtfqLBjykGQxdr4cTfjqtA+YWCmDmW+YJzgSQ4qDBMeG9ekchy qAwtDkIuqeCleUhsltGSDimBVaDFuB1XlhWpNelQGWQZ053qSwVwWuygQGybmkjFrUXCUO8t+HLa TL2iTJbnEFkzlVe3oct6ULnkKzUpGiLFCz6zeTludvLz6+ISOJ1PcrcZxXh4Vh+vb35zeV2OjwOs 89ba98NYngP0SbxUAHewihIP7yq0uO/xvOEonJbmaYq0VMF7b9YKJxtr4Arq2p08Yk2h4nEWFlqg z4Bf8+gbTtx9VHk0raJZV6A+M132DpRfPzf8/23c6Lh++G/8E30D302mMQMAAp4AAAAASUVORK5C YIJ= (where data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAA8AAAAQCAIAAABGNLJTAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAOZJREFUKFO9UrsVgzAMNMxiKPKYwJkgjyYVI9gladJlgzSkTEagogmeACbg pcDs4kj+xVRQRYWfJZ9Pp7MTrTXZHeluJAIDWgoht2+CEt3zgGONwkpUNRXVMAMxWN7DCgsUIzhC QoqMPCXLPLFDZslpPQw19Y3UZ2RVienyOHZnrZ/A7YUA9ypco7gDojGssEhGkBpXvSc0L3ivqjYL zqAOGBBoxva9WHUrv2lZsWm2J7J7GdG0vvEAT4kUScxX5GZKmJ247enakMvdPsbPS8zcpP4BTOq8 Rll+Suv3ViT/+FXbPwoQXxVt6mEIz8EZAAAAAElFTkSuQmCC is the strike price of the manager’s call option). Indeed, setting at a high value induces the manager to undertake Project III, but limits the positional rents the manager can extract. Positional rents are returns above the manager’s agency rent, which is “the minimum expected monetary payoff to be left to the [agents] to preserve incentives.” See Tirole, supra note 49, at 117. However, if a project riskier than Project III materializes ex post, a high can make the riskier project profitable for the manager, while the same project could be unprofitable for the shareholders.

147 See supra note 13 (explaining this Article’s specific use of the term high-leveraged corporations).

148Conversion rights allow investors to both withdraw the value of an investment they have made and simultaneously reinvest this value in another investment. Convertible bonds, a classic example, allow convertible bondholders to turn a debt participation into an equity participation. Puttable stock provides an additional example. This hybrid financial instrument gives the holder the right to put stock back to the issuing corporation for a predetermined price, to be corresponded either in cash or through (newly issued) common stock. See Sepe, supra note 112, at 151–55 (examining the governance implication of securities providing for conversion and redemption rights).

149 See supra text accompanying notes 29–32.

150Assuming that monitoring has a cost data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAYAAAAQCAIAAAC6IZmZAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAFJJREFUKFNj/P//PwMqYELjA7nUFGIA2ggE29Jg1qRtAxl/Z6K115UJt8Ey VlqqQFVAFVZgAShgwBD5j+wuoAHp24EG/f9/e4IVxGyodkYq+hEAMrpAijbyUXYAAAAASUVORK5C YIJ= for the debtholders, the initial equilibrium interest rate is analytically determined by the following condition: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAJsAAAAQCAIAAACOdJrAAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAzlJREFUWEflWD2W4jAMNpyF3WIeJwgnABoqjpCU0Ew3JR1NKENHuxXNJieY nIBHQbgLKzt2/BM7kYnnvRnWTUiQre+TZMny6PF4EDqKZHZ7/9xM2Mv/Mu6H2Z6sCVlmr0N8XDuv SHZvp9dhhY3IyeYzW2KFf4gc9WiRjM4rc3tC+I7YSAocFTphdrjjhD2lAKGKw/JKkYbW7mZkAPBk 88XijzzmGqK0ghQsRpVG+odGjom3hPUvVDjOleWG/cxjXR+sBhq0b+Y7TiGwtNCBufQPuT7nHkCh BqvLpDj8FinimtnyKCPJvcQM0fDTRGsbRVEja1MAVHz8DWtaxHWEXR71VMf82ROylFXbRL5ucJpU X8gLP6+jyEQQvf1ikpPNKY3Ka8Ve7n//kPVSHKmgNAGcExw3wo3qOl3NW8tNlmuy3SNrghcYnZFI YZIj/xIEgNWkXmgNYbxHgWY5/a2ehS83WjXb34fgoRWKlUz2g1XG+2F3rFUZAywaWf8YAsDKyMHR DoAhbw9LlXeZ1A+/1MeOPHiPVtcy1neK7l8/GFZpOIqcV5CJLrsZnNXgB9NAd72zrRKJIoD2jiXa 3BvhNoB5Zk2+FgoBTAomW1zYAQjOGiyDjo1gctIqzkeRIHgYK684e8pgWhzJcSE0y+ClzcQcaJbT j0c2Z2+4la1SverIc9wHQNKn9pi0Hz9ksv2WpHXbOc/qmBkb8eSCe79dIllIYKEy/vDtX2XwaqVe D16qKH1He7IjrPrVPcEd9oTezrUBYLNun0n78RMaE2Z5x2Zd2DkiyQLixTHOxf4JW818qrKPrM/G Mhmp3Pdb5ZBmB4DNum6T+oDlskqkYboX0bXx2WYnoZzBeScnIdmbFPdxXP7DlMYpa4bEQ+twv7Z7 0Ro1xcRKVzOke+kxKbZ7aZaRsDz60Y5mS/dpf1eGabCqKq+7fN7sV2msXoGY5gzaj9Y3DN0t8xB/ 9lvIvInAt+9dHq0jE7sWvQBp3ex4QjdDk+nOY/pQbxkMVeLqJax2di3lYBSe6yBDaZOJvAXEui6c 8u6V+KZsHuo1VSAMzTXcd+M+gN8I5rKtWCQJyQZ1C0/U828y5aW4/wMgkyJRAMMZ4QAAAABJRU5E rkJggk== , which gives data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAJEAAAAQCAIAAACZVgoJAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA3ZJREFUWEfNWDu2okAQbV0L84J3WAGuAE2MTCfDUJPJDM1MMJTMdCKTwRU8 V+AxEPbiVDU09Jf+zMMzJCqn+nZ9b1VJXqM9VZ6QrGzh4UeW51lejXbde4EF4+xXg3gi2V5m8psh GB5gSt7zRJuv0+I9V/2Ht1wPW7JaRJxm1/X+87zh3wyrHW128fZwpULGmF3Xk8m6kRn5qY+zyexY j3jL+2zRG3G9FNmOCxDoc1l+eUQMYdNlVlyagJgK0q90dSgifeAvfERCwLf9mzLjbfahDvH+FkcA gHfhgKp5g9woMaF0dWelypaD5ndXmmKG/Yf1IjtdayXslK+wPHeExjjUy2Iq9C11AA886WPwkHES lN0PzH0W85m7TNxYPeJlOiJdIXT957fE8liHnz/otdHmnCe3RxWqQyL2D0RcrAhrCaGoLueQCXnf VY8bM8p+3GI+dQjEDNmeti76hXaW+rgv7k9Di6Fi6uPdkiBkt/iDb8PqG6MSg9arOE0aLFZJGGDj GvpYe7wcsvp5J6KZJt1t5kcfMUH9p8fZZQlFd9/PoC/CFwoPU97L2CPTk5YKfXuqRnPISCFDiaOx MpSK00mEVC4MSfM7ndShybc0YPT7cX/Pf4UxlKv5U5jBUxC+xbvXKcWJPOw+S9VLZamXhgzlXIJZ J3vIrcRFnEHNesB5QYo5U1PgDBzU82YuT0+WzNTSvaiB0RV281sg7GdQvYlHbrg5TlRUqkytH1GN vgmBp27CgIxnnEqcx4ESEclMyoIeUBgc+MigK5XeaEgEh5DJQ1+H5GB+HzMD+xvz08lx9m6rtBeo dsb7kBbzIivDap7HOWy5UcrXUNkGJQEUAd1QhUIuXdTDfCRpNuXS+Rr+YsJNin2ED/z2GVeebXsf +IzdQg2zNZBBcdO95v8j7qh51u8g+U1BZ5wBwmUzlNTWm8/uFEq1qspmx233m+qf/iC0x+z1cpEJ XA+lY8MR4zPX6T6N4qaof5uNLPjCfhZF5BGXQOawncEHgVIXZnEHwvMUwQF1eWk3DM+z7uLYgX+S 8+D8AIwfRsVMDXnG79TDFYP96+SusyrZNTxxp66fBGfZ9gOOFXPvtcswE7IFR91vsD9+w6Iw4I7x b8CN1jjjS3thN8NZVz3BJG6+cWKCICE95Qd3qiAdRjvkSXga3iwzL1dw3P4X3OO+uVWxffkAAAAA SUVORK5CYIJ= , where is such that data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAC4AAAAQCAIAAADmq9q9AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAASZJREFUSEvNlssNgzAMhp3OQnuomAAmaE+dIhx76h7h2hF6b5igG1QcCLuk TkhTXiGJRCV8IBZy/nyxjQWRUsI2bLcNDEXhRKkKQopqdVArO3UWspKx22l1FAArO3ZcKG3zTg/J 6iRWduo4CyTq9BKek7bMSV62fnIrO3UApOQUJSg3TsaElIJlmEh0fKb3qqRPY5dkrX7/IGAZ5fgC DXHQUUx+Mwj6BnOmhSJlMStdOsIQoqLjZKVCUfQh1ehd32RlkT9WFlFUvcJzMijHUp2iZbu2NSRq N1CmnnYJbp1xYn+y/tbTEbpXviYE7z4d09iC0cjCBZ46GzYYcUkCdcpf1wS/elzg+YA/jDnX9BlO 27aB4x7ALLjnfg6aXP7ZFhBBtvOT8AGM13MXvSMWvAAAAABJRU5ErkJggk== .

151Formally, the debtholders only know the distribution of banks that will switch to Project III. Such distribution induces data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABgAAAAQCAIAAACDRijCAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAARdJREFUOE+tVLEVgjAQJc6CFj4mCBPwbKgcAUorO0sHgJIVrGzECWQCHgXJ Lng5SLhAUAqokrv7/37uvrKu67wtvt0WJIrjH5HMQxbmctrunTKWvq0oPE1/IuN9KikxpO48E6TC OpYJzXomB3FkEFmCYKD5waI7mRJDZPOv4uk1D/KRyLzJftZQoiqUXITgYVQ6ysZh+5ePEVREsz3C wJ8xQOp7yPAQHPyxqGoE2Zpsa89KUzboU0Siqarg1hUR3uam6dcvX48qiR1pA4BOPLu6KvhxPyqC dsNdI/3Tmdet8Y/q5FBMw3qUZLK9I8hGcMazAnuzamsWZGJQB5z4lxgNiJZ4EKDW7fDlPOxpgyz9 ENbG2VZ/I1+KMBxLfbjaPQAAAABJRU5ErkJggk== over the support data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACsAAAAQCAIAAAAAghH5AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAATxJREFUSEvFVcEVgyAM1c7S11MnoBN46xQ4QTfoAHpsR+i9dAMn8HkQdrEh CFZjI5zkQiof8uH/pPkwDNmu47BrdpvcMjD1JcdRfv7y+ZTsMtkX8OuBzXapjWcAs6g0yPEomBcR 1Y1bJjsDfhkUD0ilpN8QqYLp2/PpGK9YwNNgeUgkA92drykvEPA02GZghUNHYIBimfr+bHtUjQ4O HzZyJ4AmuhLOBxhKZX8LkWEgFX7/N1Lx4RzwwZgzmzNAhHXJRuYZo1T8mGNksOIDME+S71PxCyEp A/N+NVu+B+1D74jBc0VEGeiukc732KnKGvuVn7Bnwa2nMyd8fLHOkCs+8CJrrSphDQN+c5NEwyrp jcu6lF0kTnSkiP2UxE9u2q6MOEK+Hf7UAlNreOnx7vYlfAnF5YpC5bv/O38BrZal3fplVxIAAAAA SUVORK5CYIJ= . Hence, the debtholders demand a pooling interest rate equal to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAHsAAAAQCAIAAAC5lpexAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAvhJREFUWEfVWD122zAMpnsWuUOeTyCfwC9LpqzZ5NFZsvUGXejRfa9D1k5e Kp2gOYGfBlN3UQCQoigSsiyJfqkxyCJNgPj9CErU90xKpkJkkp6/8ZlKVdNk5+W/MlFE1ibP0NZb EjlUu7RWKofRrXeMa8031H4uVfv1el+RlM3h3y6ZK+8Cf7V/KX/UdZ7RmiQR5Sq/9Y7rRWOdo1ix XSy2xQRLeY+DC0HeHp9GLM0s7NbeUIjVd/AzzqIWIbueQpqkpTWs+vtHPCzbwFZnGsYiX0scv4j3 monp5lDXT0cuFqCMltNjKlsyCso1o2rVKNFghZIZFrM3hHGWkxzzYosdEID+aX5nYw5oZbaKW+pG ezgOQF1jJWo9BFi9SxqLQzX5HE8SdTzJ911SnU+QvfoJoYMMg19vCGOTaM0LFrtAdlWunjYQc/Pb ME5OSRAwmXeQsTj+SuUbqJvsDoiMaO3z42WITB6fxetPBlxU2Vt8BhMxtgSOOqo6djZQBjab/OKG VoCTJbZrwNTUHYWuhS414jyfMPmFK2fnOG0X2mt3Nxug8s5eHBea0cly65isrUWfUWDdI1eK8l0U AA8N1dR1la2F5lLK2X3MfI+TMoG9GhG7TY/r8X4u6kV1YFA54zELfgwjdYeBIfMt47J4dnaGil4X c66ofGW8lKbk7dYT7xS7zImYh+5dRsRxQEcNYJbwID64E4MgeHkByuuXiI0WQ0xLxu9C/CN6oNBe Au2PjM6cPuK49NoU2yU8BQzqeweAxwgex83oYPwq0vEIiG+zybwuLR8AKa5PENZeVX54kuFQTE9n fcvAtOS9FE4X2+Ur+rPY6iQIVhCmzK/3aeU9lotXdWTPyQlhEaODK/zWDn607YS+FTc+9Rlj3/LH +nDUer77jZAxAWYbtfrm27/HNxd34nF9tWpvXswHrFGx6y6+6FinBXG5eqaHtbgPj7tfr7AHjvkB y/bLw86KsuI+PB6Yaj4nmDubpO9aGVw7HPyM4p4bCPkEiWbezX3oQgsAAAAASUVORK5CYIJ= .

152A credible signal is one that can change the debtholders’ belief. Let us consider the case where the shareholders can credibly signal to the debtholders that Bank Alpha will not substitute Project I with Project III at the convex cost data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABkAAAAQCAIAAABshEP8AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAARJJREFUOE/NVDsWgkAMzHIWoPBxAjiB2lhxBCjlEHY2UEpnS0Uj3GBPwLMA 7oJZ98vngQWFqbJJdjaZDJBhGGAns3bCYTA/YPVZQIKsnz5ax4TE9SiKM3LrUl8l/LTTQXVQpcqp IjCyYABFlQTV3gqQLFYlXyzW0sIlDG9B8bviaYaFncqjOYZRNedBXOeNiBeR+75tILocNxeKO3CK kBGJ15vWWAZ9d3yP/aug/sHZhKrvCaTPqw2AHvVcdCbGNbGUmRTWZQ40cQjaCarhYc4hWrHAdj3I SyEUFI3SjH0Ox6PIRVRw03JjY8lWGK2MfGnm5kbsa/1p3k3m8VucC3Bjl5P0XKtriKzrBZ3Nw+RP /xMfB4bpHTcUptoAAAAASUVORK5CYIJ= , where data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADAAAAAQCAIAAADfzGvmAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAATpJREFUSEu9lbsZgjAQx09n0cYRZIJQWTlCKF3AkgGghBGsrGACN7ASdtE8 yZPk+wKSDnKPX3J3/8B38RqqM7CFu5RYHebe52qg7nv+tXQxlgalhEENcZVUACsBpZD4fbYG2jnL 4toayO2yFKC+0M+V1eN6FXIiiRsa60zkLHrLhtCUJzYAYr1uhwhQIBr3DBhQILJ9fFxpTjLB7495 /v7Z4nsUQSMMRhM08+kA2MgJDaDDZ4uJGkiZVBhPN0Z1SHmFo/EJd9Opn6BJgFfaiGlE8Awgnd/r 5zdQQKyH5Jk7KJ2GRRfcun9DTWRHI01oNmYoHS3ZJP1zV6EMdI2fKZkTzazoTDq9ZCnvj+FjZzQD dtjuOV9Cq2R/lBVATVwm9PwrK3X0ZYiefSWgNicopHWjL4MLxJ6BvJUbP1vXum/w3NjLAAAAAElF TkSuQmCC is the level of effort exerted by the shareholders to signal Bank Alpha’s type. Using standard assumptions, when data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAB0AAAAQCAIAAABlb+OGAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAJxJREFUOE9j/P//PwMNABMNzAQZOWouJGBpHA53JlozQkD6dtSY3J4OlUCl rCfewYhxFEOA6ez2BCsGqwm3ISwIg3SAZgjD///b0qCmglgMadtINxOoA90QBrBhMIDFUGRpJJ+j eQvDEHC8wRRtY2jBCDbPmVjdfzRfBS180QyBBC8EkBkGIIvRDWEcYuUDddwLTNtooU0dczELRQAm PD1YSK7bwAAAAABJRU5ErkJggk== the signal is uninformative and data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADEAAAAQCAIAAAAwDgDYAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAXRJREFUSEvNVjtywjAQFZwFUzCcwD4BqVLlCKKEA+QGNHZJurRUaWKfID4B Q4F9F7JrCcmS1tLOkGGiBlneffv2o2fELb26Mhd52YWGky/SmDELkXKvJc3n7ge8SL4p3Mj7BCdg JOsE/J+zspywEfelM8ejJCVgzGEeScxE1mE1p+FYh4e92nEp8Q0pYpCQimymc+A0MaupUbIR+JYB q7Gr3s+hXc1h38r33cK0Tm3661msl8FpVczU2jbGIVvl7aVz/ZuttnN/iqof22GQ8UIY4ITH8nXj MSIf+6rITm+oClDa89VB9x02R3KEfoLcbeKQGqLMRf99avNVxqEEBRXlJ4JiacMacjAIGz857J0g WkTBN18fot1n2IsXUd+O8dLyerdYrm2o7qKqM9xkc+OdW+1P7ui5lo5QPjDjNrx775CVJ02kFlgJ c1WLLRq0SJnwGjWq49xYD2qmz/R/f1smxN/WIBx73eAnf4MHotjvZ/5X+QXRr3cDtv2z3wAAAABJ RU5ErkJggk== . Instead, when data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAB0AAAAQCAIAAABlb+OGAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAKNJREFUOE9j/P//PwMNABMNzAQZSStzGakSDoyMjGj+po65mIFJq3CAmntn ojXQLyCQvh3V8u3pUAlUynriHQxHohgCDN/bE6wYrCbchrAgDNIBmiEM//9vS4OaCmIxpG0j3Uyg DnRDGMCGwQAWQ5GlkXyO5i0MQ8DhC1O0jaEFI9g8Z2J1/9F8FbTwRTMEErwQQGYYgCxGN2SIpl+q lz60ym8AxJ49WOFXTV8AAAAASUVORK5CYIJ= , the signal is fully informative and data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADQAAAAQCAIAAADWJ8ucAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAVxJREFUSEvNVbGVwjAMlZnloOBlgjABVJnCKS970Jjy6K69igZ7gyxBdslJ thPHxrmYHDyiSvGTpS/564e1bQtLtdVSgRGuBHDNacd2pybShSoZK9UL28NnNXYTeV8mFzd3qD/u EdhrkkMf3ed6kgMDZFx2KJ2XUBi7Soiag1eDo6FF8qdWpeu2nYch4OC1mfv965lPAkcBkeSRmu7p vfj7LrqaARvCCWCYTSR5LgTiMBH2HMGNNR6eu/mGYOaOjhBZcgcwMCOiXkFz/anz7Xpy59SxAvH9 +QGAXp1t0HmmUVJe7L2URkoSSqnLGepqzdAOINsvPw0E7ZHIRCxQpH2RVUctRao8nLksLlaYcGAZ AfUp50hg6OnGPpAM7zUsjf+7ELaQvx96W4f0HXLW49LIMgQ9PLyuf12wOjcWMk31VL2Zg3oCXDfX uMrSxF+kv7oXRlq3VEv48b8P+i8PdMGEJe9u5wAAAABJRU5ErkJggk== . The signal has the effect of changing the prior belief of the debtholders in the sense of shifting some mass of the distribution data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACQAAAAQCAIAAADxiUp0AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAUxJREFUOE+9VLuVwjAQlK4WfMG9q8AugYTIJZiUIijAboOIBNOBK/C7ALsX 3a5Wn10kPzgOUIKsN9pZzcyijTHqXevjXUTIcwfZ3FW66uY/d3Xear09i2sgozF9c1Wq6e25mdpS le1EHw8sKMyuq1jUEwC1AwDVf5h8u6GGI5MduCc8g4vEce8gz+bLWNbrFWy6Ksg8nw7D9ycc0kIL rAd2s2Ai+ksrlFmt63K8WMstGZYddgVAip36KjJRgCLHDfQ47ittN6yLAAdQcajRYERSfVrDz2R/ XT5I16ltYhrY+0lXjFEwNk1LtEICYx0kyxomxE6szgSTJ1q0FK0HGcEwlVOFie21TmDgHxslH7te 7eNccut9Qzl9hJAATDACgB+0OI5H2kV/aV4T3wQwDOTiuMvpuUHmc/HIbKNm8p6Gcpmov+bojj/i 5xH/Ags2K2DQWitFAAAAAElFTkSuQmCC to the left. Then data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADQAAAAQCAIAAADWJ8ucAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAZpJREFUSEvFVb11g0AMFswCLnhMcJ7ASeMN3B1lMoDLdGmgdLq0VG4CE4QJ eBQcuxBJHHBgv0AItlXYcPr7TtInoK5rFQoAEELIBN/qRIpQ0YOWRDbnbCZD/uUDLY07aKfW2jBY /GhDGhzgE/2PPnguJqnKPHt1LStIKaUpz8dQfMRkfNp151X0TieJHFuv8G4jFn/jMCb+B1X4XJcO gOtBWaHCcQBV3y9k1GP7ivP4YFnnfaOoyuaK60h35753w65yo1mpQmn0G7tJp23JGqf/NVUPSDci MG8gEMIY8gUOCj0YxnmhjdnWw0yBONtMcH/MM2XepR/wrr+/roW9znDMjZIGFglRcDy8ZT4IkhUK 7gROg0LecK1GwFpUDSNRXI+3k803WV+MKhAwDcrcQVeKnfNW6MWeGo+FeiPF7lTX+zPf/3J3dnbO xu99VJEJ2kgLky9za/fOVVKTUq+sh7KVcFxsU+Mzo8FbWIK5VLu73SRbmWe/zMotEU+Aq6ISya+8 t4fAm6xc/IQ7M9b1qaItkW4bDSl/q+r9ABVS8Ju0CGZKAAAAAElFTkSuQmCC . Therefore, as long as Bank Alpha is undertaking Project I and assuming, without loss of generality, that , Bank Alpha’s shareholders solve the following maximization problem: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAPUAAAAQCAIAAABBWq4DAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABX1JREFUaEPVWj1S6zAQVjhLQsFwAnOChCYVLZ1TJg0dJR2NKfHMK2ip0uCc gJwgkwLnLnm7+rN+LUtW3vBUZBxbu9o/7X5am5wvOZqyqFpcoCnLRl2oqdh9NuApDJjQVmVR6DMj xJOrcZq2KkgsM6DhIkcsHDsVBSNlRX//4C8uSW9qF7Fsf8N8y34pTsioCMnIy2JFXcaGDJqmFLfk 3baqGtwAEN0VBLga+RHSmdGNuyU6vkG61PUDonJbUO5t24BoF1oowmQXmQomVJNKghNyinWlRFv2 y/Z4S7M26Hh7PWXs5+80Y7P8/b3Guy0hs9nNYfFInu7JQc6MEWe3mmyXjNuYsdvW5fNoLg4JTm+P x2csVPTZdErAMuPF9ap6erub3L2dok0BZpysdtFkGsF8WdbbkTyCEngUtOW/YHyf3l7qww8Yefe6 2fsl3q0Wm2M7XX9DtLe9M708gEVN6sUk5FNUvxt2AEB4Fzczc5kMTj99fRJkPH9nQX36oX+zDHQ1 HTww8f8j+eC5I24JTD7Lrd+MbK3ADpjdFLkCXOoGq0p39SjokD9nMfhlvOzSqNyRcLcT2prPMEVR hGCOUZJtMwQnJFsOKwI/udCKmOP80McDngWPNBp9Oj5hpxR2bOuWHaCgOuWC+Tsudfyr2SJBT9cf VbE/AjaSoz3u9fSNReV8/ngYK9vp5zCWhYceK071NAfIs37HyoCF4uF+JEyb3j+QzasbYrTHQZVH N2yK8oDoNqRq30E3RHTrb3Y1REFV/itRcngpwCrAy7hSv2WdwHviTzc1Beql6DyWBoyz1+E9xU98 YBQmgf+gWLBxgnP6J1CXIC6gF8ze6AfAZfvNrMMmuoIuKmudDgNI3AEBUqiWERExWa22tTCRn/n0 +pZo5AnKI6Z1HIVsD8pwVHCTIv8V7AyocTUc7j6wDBCw1nZJe3b7zy/qfDAAfSjuYVbDPgPmCcBa UEEueFJKMI2fBOKsXLKEwMdl4jmr0NQB2yUU3cPLHfhGHtaZ51gXhqc5dWEPlS4bTJp9PnBgo8Vk l4EhkBcH1tRakpoZcBDzEWbAXGO4ysktLD8NW9nR6S5dOEe9x7FpTzNvhHpq11JrKHY8le6asZDE sib005t/+FRr0fmQou9+WDAhiQDJySibOclq5jsPDBo8DqzcWUSfqDJWrGbEhJe5amjbegPsZvlG WM7gFpZ/EP4WJWxm9UH6cNYYbyohyxqK1lBqhvHMt68gJ9Caw4anAEZsyk4w7fg4uJjJAj9kTRSe Am1lYLHuT3IuKoUBoHcGbyaTBWn0IiBOIojwudUM7Btg7tUq7FBKOqC0DpA/HN8dPBHtWwWyNGTx v4BvAuhEwY6Lumzsqj4WNnqd6ug7UmznABYuHg7cCe8NzPMwMYCzkwq2ldLgExWsIS9dv9xDB+kN DLhbMXLnpCFbdcAcRPCyx6gKbJ0MgvKLoIWyxl+xYRlULuU11McS309gvwwG1kFeauRbZeU95Zjs nYlWLWZCIW5cZ4/LfnmpU3kbY6H2n/u5/cLVr7eLgxMeaAXcRaVN6PQzXjkqwE3ACXy/jI4XM/1K W0sEO4oOxVUUo8LISPkzvZ/HV+twAolxWaYg7mET23qNnS+XDsS3u2Ub2hQh+8QeFxi/sIcGNJgD oml5Itmo3kUCHHX588Q38sSsnrJRQ35Mfx5t2miCkGzsszIRUzT/mZ9VhVj4nvfKiskv5fOWVDpN SD3AstuUb1Ongrb8eeJbIvOwUWXdybgXPDzjTTs+d5meRjwkjJLvsyqqcEYDpm4yF51hw3gn5BTm nCm+o2UyP5iNZuCEbLrLU0w7FjX068G1puFZwLeS9BxDDzW/NVqj/WKmiBQnRC/qJ/gLPbJHPfOU 5AsAAAAASUVORK5CYIJ= , whose solution data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAsAAAAQCAIAAABP3xIpAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAIlJREFUKFOlkE0ZgCAQRBe7SAhMYAEjkMQAUMMAUMQT0GVdED//EA/MkVnm zS5DRKiqq9vktkxYrUMCUI+CjEymUB5Zuam1FpwDzvsxZ3glcmVpHpGxadBDv0yeHBpc3U4/hUjM yCNF+isD0vOhl03f0j1yBBqY84Z3SqVlRH9se8loufoR85+xAer2nHmjFBWFAAAAAElFTkSuQmCC is given by the first order condition: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAJUAAAAQCAIAAACQvapzAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA1lJREFUWEfdWDty2zAQBXMW0oVHJ6BOYLlRpVYdWdpNupQ6AFlaM8lMWlVq Qp3AOoFGhai7KIvFhwQFcgGBlhOj4HcXu9jP2wXYxXVUWVrUFHFdpIxlBV5/8ivnwY/GAzWN/I+M LE3TrOJfqgzexEz8RXxsS8QPBq8k7spTzI56/MNkzFG3Ae8JKwtL1XUFbw6OdhCrRDai6yLTIaT9 Z5UoKfu0/jr++4YhTYxdHm3n7y+xjexcLo8/dG7EMTtOqh5SSoz5/3w6TB5ApLrD058N419wJI/s dIa7VSJQHjbLqE/r84k9Jn7a3IH6XE6jacnXRLsjyneSiE4ECVsKuEwGSD4j29opQk89SKHkCpxE yDREySQyJYI+nF7xWpFgMPsEmmiZgWvQCC+trfS5NhuFWlVhVC9YIM7lip9964B5xlzrkLmuwVAt osVFISN3D6GwDIERPKfLs4jA1sTmWrrevBJtVP6mwIMHA/3nYI5x7PCpcXLzErh5bBBgRhnpvksF oyjg0m4g0faB/uOBEZx/GF0a9cZpfrxNrtE6axBlQDFdVMxaZSrvZh1LDsiWkABy7nen/oUqqCH/ oWpv56DJYTWFdgMesGm584AGbXYQ9WXO1tn8CeQPK/b0Zo0Qo3ODzouJubwGCE42C64MNws2ab1j D/lHhFKH11TbLcLIZLBN47Xm24iVXq062sGykPX1gWfXGp38a5ShhHNGyD8ilDriXCwF4Rw1HS7N AYGaFt87gUo6PZxAarbbrtPFM2Y936LIR3y1KYZcuMTr0e3//cEElGH714RPPWPV5W04fUfAz/R6 K5U8QhNPSG55FYy2918oHRbeFLs8eeWa7HKxvRpQzAE/44cJW2/lPg38rbdsHb3i54UJk6qIVmw1 tB1E7cL7F0v74nTU1qTPHXtLe842O01z9xesWLs0DfRlBoK69S5YHIP3D/bON3jZ4cj4v83gvQ9T lr+1/xQQUx9FteBHP1Fe4vVXuVozom3yRrZeBt9SO57kUWeKX94v823kfn62ZL9Fr0tHqgaBFlK2 z6x5ozvisTWtUENRw6bWONfwYf4StA75J0u1sc3g8QJDbXf0ITKmw7QssTvLc3FTR62jRqycbDOL ouVGviAMOAbxRyjzCXP+BR/Av/bC2rlAAAAAAElFTkSuQmCC .

153Two considerations are worth exploring here. First, under the original assumptions of the example, the compensation contract of Bank Alpha’s manager perfectly aligns her preferences with the preferences of the shareholders. See supra Part I.A.2. But in reality, Bank Alpha’s manager may have private reasons to continue to prefer Project III even under the pooling interest rate. See supra text accompanying notes 143–46. Hence, the shareholders need to monitor the manager’s activity in the negotiation with the debtholders. Second, note that because bank assets create a high level of adverse selection, even a single agent’s attempt to distinguish herself would be enough for the principal to conclude that the remaining, non-signaling agents are bad. Thus, if Bank Alpha failed to separate, the debtholders would infer that the manager will undertake Project III with probability 1. Therefore, they would demand an interest rate of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACkAAAAQCAIAAAAEd8HEAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAXFJREFUSEvtVSF2wzAMVXKWtqCvJ3BP0I0MhY4lsCNjg2MjCexYadFIkxM0 J+gLmH0Xz5JtxcmcDvWFTKS2pC/JX1KaaK1hJklnyotpZ8+tqm3iZFupgImmSJKiiVETh6C/FUZ5 xyAMquiqdZ0D5LXpu9ayFO5MJxBCeBPZvUQhRhkLI0pJgekXhf1SUN9XyJ929LjFY4Yp8bS/GLdj Fh2HOGR30IdxGNm1m9XChFtt2k5isKZ4gNr6paiGzy9LrDqfWl/HjSH8E2JSivUyEkFV79fy1VaI nHuu8eZI89wi8yNVaKIAv+09+dREdHCcW4vtp++37wVquS+uplhuE+MGJIxA0+RK5MxuBACNvfMo +cS7JyHhSA2G076D8jArdQrLtWhfPtwimUYBDUdMeOMmIKp67t4ue0Krqhhsq7GdsqO1sbip93em gJvSNzXYLKbSWB1kCGD1aK/698vSztqdZdAj+0HBmpP//5L4gN1R+wPAYHAUgw9LBAAAAABJRU5E rkJggk== , jeopardizing the conclusion of the debt contract. Under this scenario, sending a signal to the debtholders might thus be the only supportable equilibrium for the shareholders to raise debt financing.

154 See supra text accompanying notes 138–40.

155 See, e.g., Sepe, supra note 112, at 145–46 (explaining that the rigid structure of debt covenants may deprive firms of the flexibility needed to pursue profitable investment opportunities).

156 See, e.g., Squire, supra note 11, at 1153, 1162 (observing that covenants need monitoring to be effective and, therefore, may be costly).

157 See Tirole, supra note 49, at 167. In addition, deadweight losses may be attached to collateralization, including ex ante and ex post transaction costs, the presence of ownership benefits not enjoyed by third parties, the suboptimal maintenance of the pledged asset by the debtor, and high opportunity costs upon financial distress of the debtor. See id.

158 See Levine, supra note 93, at 2–3 (pointing out that banks, unlike other types of firms, can quickly alter the composition, and, therefore, the risk, of their assets). Moreover, financial innovation and the development of risk-distribution technologies have hugely increased the ability of banks to “play” with their assets so as to hide actual risk exposures. Cf. Robert P. Bartlett, III, Making Banks Transparent, 66 Vand. L. Rev. 293, 295–96 (2012) (arguing that the opacity of financial institutions was one of the crucial problems of the recent crisis).

159 See Stephen A. Ross, The Determination of Financial Structure: The Incentive-Signalling Approach, 8 Bell J. Econ. 23, 27 (1977) (suggesting that in adverse selection contexts manager liability might be “a means of validating financial signals” which would otherwise be useless to achieve separation). In different contractual contexts, scholars have discussed the benefits of liquidated damage clauses and private antifraud rules as validating signals. See Robert Forsythe et al., Cheap Talk, Fraud, and Adverse Selection in Financial Markets: Some Experimental Evidence, 12 Rev. Fin. Stud. 481, 487 (1999) (arguing that an antifraud rule punishing sellers who make false statements as to the quality of their products constitutes a way to give the “seller a means to credibly communicate its quality”); Lars A. Stole, The Economics of Liquidated Damage Clauses in Contractual Environments with Private Information, 8 J.L. Econ. & Org. 582 (1992) (Eng.) (arguing that liquidated damage clauses may be used to communicate valuable information and move from a pooling to a separating equilibrium).

160Venture capitalists’ claims are most commonly structured as preferred shares. See George G. Triantis, Financial Contract Design in the World of Venture Capital, 68 U. Chi. L. Rev. 305, 312 (2001) (book review). However, as observed by Douglas Baird and Robert Rasmussen, “[w]hether the venture capitalist formally fits into the pigeonhole of ‘creditor’ or ‘shareholder’ is something she cares about only if something turns on it.” Baird & Rasmussen, supra note 4, at 1217. Baird and Rasmussen also observed that in Sweden, where venture capitalists do not have the bankruptcy-related concerns of their U.S. counterparts, venture financing often takes the form of debt. See id. at 1217–18.

161 See Malcolm Baker & Paul A. Gompers, The Determinants of Board Structure at the Initial Public Offering, 46 J.L. & Econ. 569, 570–71 (2003) (gathering data from 1,116 IPO prospectuses and finding that “venture capitalists institute better internal governance mechanisms”).

162 See Jesse M. Fried & Mira Ganor, Agency Costs of Venture Capitalist Control in Startups, 81 N.Y.U. L. Rev. 967, 971, 988 (2006) (observing that start-ups have unique governance structures).

163 See Baker & Gompers, supra note 162, at 593 (“Venture capitalists appear to be a counterweight to CEO control. Not only do venture capitalists reduce inside representation indirectly by reducing the control of the CEO with their concentrated outside ownership stakes, but reputable venture firms are also directly associated with greater outsider representation on the board.”).

164 See Randall S. Kroszner & Philip E. Strahan, Bankers on Boards: Monitoring, Conflicts of Interest, and Lender Liability, 62 J. Fin. Econ. 415 (2001). Kroszner and Strahan report that almost a third of large U.S. firms have bankers on board. Id. at 416; see also João A.C. Santos & Adrienne S. Rumble, The American Keiretsu and Universal Banks: Investing, Voting and Sitting on Nonfinancials’ Corporate Boards, 80 J. Fin. Econ. 419, 437 (2006) (finding similarly that about 25% of non-financial S&P 500 firms have a banker on their board of directors).

165 See Kroszner & Strahan, supra note 165, at 419 (suggesting that the presence of bank representatives among outside board members reduces information asymmetry between the bank and the debtor); David Erkens et al., Affiliated Bankers on Board and Conservative Accounting 7 (Mar. 2011) (unpublished manuscript), available at http://www.bus.miami.edu/_assets/files/faculty-and-research/conferences-and-seminars/finance-seminars/Subramanyam%20-%20Paper.pdf (“Lender representation on the board increases the scope and dynamics of the firms’ relationship[s] with their lenders by allowing better monitoring and increased control from the affiliated bank.”).

166This view is supported by empirical evidence about the positive correlation between the lower costs of debt capital and key governance features, such as the presence of a banker on board and independent directors on boards or accounting committees. See Ronald C. Anderson et al., Board Characteristics, Accounting Report Integrity, and the Cost of Debt, 37 J. Acct. & Econ. 315, 332–33 (2004) (finding that yield spreads decrease with higher numbers of independent directors on a firm’s board and fully independent audit committees); Daniel T. Byrd & Mark S. Mizruchi, Bankers on the Board and the Debt Ratio of Firms, 11 J. Corp. Fin. 129, 132 (2005) (finding association between bankers on board and lower cost of debt).

167 See supra Part II.C.1.

168 See supra Part II.A.1.

169 See, e.g., Nestor Report, supra note 53, at 4–5. The Nestor Report observed that the CEO also occupied the position of board chairman at all major U.S. investment banks before the crisis, with the CEO of Lehman Brothers having held his double appointment for eighteen years (from 1990 until the firm’s bankruptcy in 2008). See id. at 4.

170 See supra notes 163–65 and accompanying text.

171Augustin Landier et al., Optimal Dissent in Organizations, 76 Rev. Econ. Stud. 761, 769–73, 775 (2009) (Swed.) (providing a formal model that conceptualizes the value of dissent and preference heterogeneity in organizational models and information production). For a description of the interdependence between decision rights and information structures, see Philippe Aghion & Jean Tirole, Formal and Real Authority in Organizations, 105 J. Pol. Econ. 1 (1997).

172 See Landier et al., supra note 172, at 762 (arguing that “dissent fosters the use of objective information in decision making . . . . as it allows individual biases to ‘cancel each other out’”).

173The seminal economic contribution on the informational and organizational value of advocacy systems is due to Mathias Dewatripont and Jean Tirole. See Mathias Dewatripont & Jean Tirole, Advocates, 107 J. Pol. Econ. 1 (1999) (providing a formal discussion about the use of such systems in various organizational contexts); see also Paul Milgrom & John Roberts, Relying on the Information of Interested Parties, 17 RAND J. Econ. 18 (1986) (providing a seminal model on decisional mechanisms relying on information provided by interested parties); Hyun Song Shin, Adversarial and Inquisitorial Procedures in Arbitration, 29 RAND J. Econ. 378, 378–80 (1998) (showing that decisional procedures in which “the opposing parties are invited to make their cases” are superior to procedures in which the arbitrator adjudicates “on the basis of the information [he] uncovered” because the former procedures “allocate the burden of proof in an effective manner, thereby extracting the maximal informational content”).

174 See Dewatripont & Tirole, supra note 174, at 2.

175In the words of Justice Scalia, what defines the adversarial system of justice is “the presence of a judge who does not . . . conduct the factual and legal investigation himself, but instead decides on the basis of facts and arguments pro and con adduced by the parties.” McNeil v. Wisconsin, 501 U.S. 171, 181 n.2 (1991). The American Bar Association’s defense of the adversarial system also provides a suggestive representation of the inherent merits of advocacy in decision making. See Professional Responsibility: Report of the Joint Conference, 44 A.B.A. J. 1159, 1160 (1958) (“[A]ny arbiter who attempts to decide a dispute without the aid of partisan advocacy. . . . must undertake, not only the role of judge, but that of representative for both of the litigants. Each of these roles must be played to the full without being muted by qualifications derived from the others. . . . If it is true that a man in his time must play many parts, it is scarcely given to him to play them all at once.”).

176 See Dewatripont & Tirole, supra note 174, at 2–3; see also Shin, supra note 174, at 378.

177 See Basel Principles for Governance, supra note 20. Among other issues, in the new Principles for Enhancing Corporate Governance, enacted in 2010, the Basel Committee recommended that the CRO should (i) “[be] an independent senior executive with distinct responsibility for the risk management function”; (ii) “not have any management or financial responsibility in respect of any operational business lines or revenue-generating functions”; and (iii) “have sufficient stature, authority and seniority within the organisation.” See id. at 17–18.

178This means that the payoff schedule of the CRO should echo the concave payoff schedule of debtholders. See supra Part I.A.1.

179Because of the specific investments they make, individuals within a corporation—including board members—tend to be risk averse in the absence of contractual mechanisms that induce different risk preferences. See supra Part I.A.2 (discussing managers’ intrinsic risk aversion).

180To this extent, the organizational features defining the board of directors under the advocacy system envisioned by this Article resemble the “mediating hierarchy” model of the board articulated by Margaret Blair and Lynn Stout in their influential 1999 paper on team production in corporations. See Margaret M. Blair & Lynn A. Stout, A Team Production Theory of Corporate Law, 85 Va. L. Rev. 247, 254 (1999) (suggesting that “directors should not be under direct control of either shareholders or other stakeholders”). However, Blair and Stout viewed the inclusion of creditors among the corporation’s factors of production (i.e., team members) as just “possible.” Id. at 253 (“[B]oards exist . . . to protect the enterprise-specific investments of all the members of the corporate ‘team,’ including shareholders, managers, rank and file employees, and possibly other groups, such as creditors.”). But banks’ primary function is to produce liquidity. Hence, in these organizations, creditors—together with shareholders—are a vital factor of production and, therefore, an essential, rather than possible, governance component.

181 See Dewatripont & Tirole, supra note 174, at 6.

182Milton Friedman and Anna Jacobson Schwartz famously noted that deposit insurance “has succeeded in achieving what had been a major objective of banking reform for at least a century, namely, the prevention of banking panics.” Milton Friedman & Anna Jacobson Schwartz, A Monetary History of the United States 1867–1960, at 440 (1963).

183The events that took place in the repo market during the crisis provide a vivid example of how bank runs have expanded into other categories of bank debtholders. See supra text accompanying notes 86–91 (discussing the implications of the increased use of repos and other short-term liabilities by modern banks).

184 See Mathias Dewatripont et al., Balancing the Banks: Global Lessons from the Financial Crisis 4–5 (2010).

185When insurance is implicit (i.e., not expressly provided for ex ante, as in the case of deposit insurance), bank debtholders are willing to accept lower interest rates for two reasons. First, they may expect to directly benefit from future rescue intervention by the government. This explains why this distorted set of incentives tends to be more severe in too-big-to-fail financial institutions. See Macey & Holdcroft, supra note 2, at 1371. Second, debtholders indirectly benefit from both explicit and implicit government guarantees that are granted to depositors and fellow debtholders because these guarantees reduce the risk of bank failure. See Squam Lake Report, supra note 66, at 21.

186This can be modeled by observing that in event of default of Bank Alpha the debtholders will be paid back with some probability data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADAAAAAQCAIAAADfzGvmAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAYlJREFUSEvtlSGWgzAQhoGzQAWPE6QnyK5B1a4DCWZdJW4NSHBrq2oKJygn 4FUU7sJOEgibkCxsH6KiY3gtmZlv/pkMZt/3xjOZ9UwwhGUboC7bm9TC6pECq5B577NuIyCgQGkL 3c8xA+KEJIfKCAOnxzm4lgE9t41CUsoqdGKvhCRtasQfEhJjTRqk1nIt0KjqpK2+N9W5QOkn0cqO jkF9uggi2dEVUL8PGn8AEnPxZv5ygBOJSzoy2jWy9TzdvRFe1rf2H4NlVeHZB2lRwCRGdBbEhFBx cPwLYZ7P2w3EjqtpjY7RwnmOu8vJ80FieBqHd1XxxRvr1WC6UeVZmrt6lpelojPU3gzXoc+alya6 Uv1WtszeeZMzhEQ09lojQNASykFa4+MqlJcJ9oMi0VxfVR44X8dfZCN1WVIgpjnM4bolRe8/EwAm CDwlMZgs7BU3tnQmG2eP/zMslSkaCTBEFmPxdOBCwhpC4Ed/zIDkQGUg1zBLtTUQU08p72KZo54E 2nx97Reu2w+M7/tjRFXh0gAAAABJRU5ErkJggk== .

187 See supra Part II.C.1.

188Analytically, the taxpayers will suffer a cost equal to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAFIAAAAQCAIAAAAK3r+rAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAnxJREFUWEflVjt26jAQFayFpHiHFZgVCBoqt+nsEpp0KeloRGl3aaloYq8g XgGHIvJenNFIiiX5I5mXFDlRA7ZHmns1dz6zhrPVkcSEbLLdgvyVNSeL3Xu2+St0Nc/5VML1aTXD lZZhW8WG1akOM55oVaZjOJyv4lEsBNOAyiP0FjHe+BdY24ZFYmK1v4mjrTfCOCn8XgItisQHGhy6 AMQzRBtUjl7e78tt+gzcFBXOyP7hK7T16ekcc3WsVMnhKq94YEFAQkUkTqg/rsvH8YJEMx6fnzpi myzyXsDRvwd8v9i9sqi6cXyo384k3mhU8nJfoXZ+3+K35Zb6jltsYrI/Ohk5RFsngkyHNie6ToBd Zd/59UNkcve9D6BHBzKNERgKqj4dculqfAHvyLXrp12ml63IedSuzuaBJOC3KrHv3Cc8H87Od0iQ yxZgXA+rGf5BD0I/oYmpFaiPnhvhFH/le5plFKKFErK12oFUXnItcRVi4zGMYKusdU7ydVddosdS uN5q+dJkFJ/CTh60mjs1szXkN4IZC+5GwgdVJWoTuDzuq+RlammkmQYBdbet83YkhSP2rOiW6cSW 6IZisKRBFJEt/IKGy3SgwhqXAkFb50mhI9GXUvfHyK4UNAtV91CR6e+QbX+VXb2Ngdm3dcdXbNyG LD5bGw3W/c3biraFzPiij0XvCWvxqQnCaeX2oKH6OIwr01ZnXBnbbhP3Oxqmbe4tEllqeSGnIV17 +4YXF+5/0JZBCx22RAx8s5T/QgwLzhI1Tyqe6hpk0zF8OZ71OCnAkOZruAzlMQnjDxgjYAFW8Uex R4ypITmIxgxwYfCgaBFoW/cXnV+18xNsjf3k9k3a+wAAAABJRU5ErkJggk== .

189 See supra text accompanying note 130.

190Analytically, the taxpayers will suffer a cost equal to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAIAAAAAQCAIAAABROuDfAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA5NJREFUWEfVWD2WqjAUjm8tOMUcVoArQBsqWzsotZnO0s4GS+xsp7J5sIJx BR6Lwb3w7r1JgCQgARznvFQBkvv73T8mRVEwWPfDbMVOX2uH7/dsydgiocdXrboIr+L5+3z+cBGy /YYtF8LczvorWbxeNGe9dTf77PWMf5Ujd0B2PobbH4Z7Fk0mEZrX3EgL+EF4PFt7ACJmQouodi08 PTvcu44N/f5Au/KTwDrYAZcUBlJQkYbMi3Pc8ZXHHh1WXlafrXZAky9JJA3FztwojMPUij5JqQpY stSFR32Uo3jSmo+VOB3a6RaunjEC7t9X5r7V0j3kIOLKS0LTAq8+wh18njMyZB4znlaACedhbioG zmLpXb+HwtT/AEMLuyLfKQfZ/bD6XOZCFx42uytHWPvqUFC/2KWdn+TLz1VTAKID8tvFe58ODT7z 3v2wO4Zp4ssQINr5zQ3ojblRKVxu+QhRpCLO+hR7ROr+97Mqb4xj6wQtxlNXt3aALQFFlTE4wAiA saKBQ0Nu7CyablwsLugTgra5Ubg5by7TQgBTqLZacjmY+qJEMpIyX45Uj+TB8KcNiWKlXUt0iy5o pFDKdajogEOK9XNQFBQJCDxKAuamKxUADcjhlFlk1m9JjZXjJU3VHU9QErQ6ByDGdTcD5WBDHKy1 a4juBgdocKuJXYFxfmTHuTyoAhICyoOOFoVK2Xxs4+EniQ8gpvSlJhPDnNzx8jUiv3di7VQQO3Qf HH1xt4Asehrp1gYHaFW/xsBP5Deo4lUXoQISxJPAm77zNDxy5TcmyoiWYRS6wvHiHQw2l/6dtZWC yCj+EIbPoj4Qa0CEcMDw1kM3bg2HaITeIDSdBRTJozisBH4WtbRfNcdjEybbgHGNVQN01KLiJ+2t onq5pRiBA7DwPW0hPNzbirITGsFWPCGA2RBkEZChkg7xBGnvHDRFPeTmWlakFlge09oPqk3TzYWn UKsZTjVOrdIgLaRANKMDdbjlrFmbtZAA5s8ybuoUxdzVcyxRUlA9Z5UDidX4YhzSB5ZHVIxBrPUw DmLPUlBhkoa8OchTPurJbsGwgi5rpSeTk29PAVuUlRIMM7853HY4gCPJSnQcfsdM9k2S5HEofiAI iwuHCFCXk7/CWc7r4is5QFO8HOmtNKtLZg/KRsuOvD7Q68OvkaHQSMIT9AvHi2PxF8bKfNwB9DtI P1+5c7iIvW7+b/bvpVzb4X/gT61adj8FrgAAAABJRU5ErkJggk== .

191Consistent with this simple example, spreads applied to U.S. banks did not increase before the crisis. Rajan, supra note 1, at 148 (“Bank debt spreads . . . remained very moderate until just before the crisis.”). Indeed, bank debtholders fully anticipated a bailout and the rescue of Bear Stearns confirmed their expectations, making them confident that the government would intervene again. In this environment, it is unsurprising that the remaining big banks, including Lehman, did very little to reduce their risk exposures. Significantly, spreads for credit default protection against a Lehman bond default were static until shortly before Lehman filed for bankruptcy. See Skeel, supra note 1, at 24, 28.

192It could be argued that this argument does not apply to bank depositors, since this category of bank debtholders would be structurally unable to monitor bank risk taking. In fact, whether depositors would engage in active governance in a world without insurance is highly debated. Some commentators defend the argument that free-riding problems and the lack of sophistication of most depositors prevent them from exercising adequate monitoring. See, e.g., Dewatripont & Tirole, supra note 12, at 31–32. Others, instead, argue that without insurance, depositors would exercise governance to discipline their banks’ risk taking. See, e.g., Macey & O’Hara, supra note 93, at 98. This Article is inclined to agree with this second view. Deposit insurance currently covers up to $250,000 for each bank customer’s account that meets the requirement of the different ownership categories the FDIC’s regulation provides for. See FDIC Insurance Coverage Basics, Fed. Deposit Ins. Corp., http://www.fdic.gov/deposit/deposits/insured/basics.html (last updated Aug. 22, 2011). This potentially extends insurance coverage up to $1,250,000. It seems thus reasonable to assume that at least bank customers holding similar amounts would monitor their banks without insurance. And even assuming that small bank depositors have limited ability to discipline their banks, this Article’s theory of bank governance is still robust because interbank depositors, subordinated debtholders, and bondholders would have both the incentives and the resources to discipline banks in a world without bailouts.

193Here, the participation constraint is determined as follows. The debtholders expect to receive the value of their claims with probability data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACcAAAAQCAIAAAAavvF3AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAATJJREFUSEvFlTsSgjAQhjeeRS0cTxBOwNhY2dqFUhs7Sw8AJaWtlY1wAjkB YyG5C2YTYhZhxpGJuhXLDPvt49+F1XUNP7fRz4kIJFSZBCxI5FfSyCPGotyFVh1WVsUceFwZBy0T ACJzvocnFdIioGE6JCYAwDn3TdW1GQ5Snw4pCNmea21ailHVXOXlVMynY3/zxCHqKeoHqpXxYsXL u6Rq8oTNo/NSdao8BOy8RIEUpwuVaHGrPqaa9DtGtB+maVjdClgd6zQEmMxQJi/26b6Gaa+arxs6 IXkvxd686Y6PzyZYq222pw4bkgkmk/UW4p0qufGthOy2OsGa1bE2QMiZ4EKYGK0b0N4cImkPxwBj 96ZKFlRfCXeO2rkNyqFv+/WpI7EJdRCj+xEC3h0Y9pc/3QOyrTbuFjEY6gAAAABJRU5ErkJggk== when Bank Alpha undertakes Project I. That is, they expect to receive:data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAfEAAAAQCAIAAACJP9G5AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABzhJREFUeF7tXD1a4zwQNnuWZAseTpA9AWxDlZYulNBsR0m3DSmho6Wi2eQE mxPkodjkLvlG/xppJEuyDPliu4HEljQz78wraTTO2eFwaMZrtMBoga+zwH75Y3q/gfEXq8Pz5dfJ QY/MpHub7/7eTY5Nsl7l8dVe355dvcCYs6fjNsa3Xu0ydj5aYLRAkgWAzg9HSOjAYzfN62FohA6Q Te7+Hl6bmx/LvcLv8hkgWi2S4PzKh3rkdJjozvh1uxYarm/VfyUas+4sA5d04bZZLw1gfn/xu/bz 4PhaSa6n0LuytF01TjZgouKO1iCeh/jJgv4ZiCfjFXeMYjQ5eFfNyuHzoUQxs+rk7nX+dhMjiayg 7GY6b6ggsjD1mGv3NFMt+bpBXPpb2HQ4XzlPWR95M9PAmt7kl8ljSQlMX3K2RIMhNWIf0DyL+mSt yLtK0piyrKUrodd7spD8QSYL1rEQCNeAluW1iIWKY60R4tiaJwh6PcQZID7SGhsyUigQtX9VQZPH PRZrcFEsnNg2got6akz7prOZFUW6edSnuAB9oSaNJZNFItS/DGLhZyp27Rh2VLee0nZZLUBG2SZ5 LNyRmmBmM9fdkG19YSx3j1HtauHdTVPWFdPjeDve2mYjEa+ujtpkuUD4s6sUgI8j/i9W3PYBzOkC hFMG3dO3cBZ3ydNbDUm8TNBY4WOBGHPyNDd20MSUfvqAelEsedcK2DJO902HF20IWT86DbkRcWrN OsIXrNzL+v1l9vRLHNFcXi+al3eWMzHfTu4eFpu3P5Be2n1sLr7Dicnk+8XmYyfSKrBJCx7v7P9t Z+dTsQOANBVs5tLHgh39n7dm/lMd0LA01+HwOs/a9HR5OFnZyc95c/9b5pm6jMhTeZ6O5UAgAwIW zeJaoAwS632ZL3Ca4kGtBwB6PcSR9RFeZKSkg6g7zkcTWuioZd0MAFAREziKgeSa7T+dVC8KbN90 iFltvoWkveRRNjACIDS01YQHdCifPj0X0c68x74kh+Pu98vHrZoNqIFhNri4n4pDY+KKjwUeLmaQ WtcGRAnnu+N3mUWCyjKK7Ip+UMlyILABmaeI2ZrPlhvF702p4iGthwB6C+LqYEW4m75azlkiDq8i JQiidp/uaDKHQ3E3BEDlQgdFMRidZD1l6wSUW0wHPSlkTfzDMnn79OoXG0WR5fOwxelMdr4Mdy+N rBoY/nJakNPP+vf9xcNdI49EyXNQdmQMG4OXK3lwmD5WLSZX/fDDa3btnpr7qSsscTdP2Sj6XXWp AAQsCZ4Pu/NHTjDTjwe1KOimOK31MECPIK6NipOuWUUkdKTQIGr/6gNN6HwYgIKiWVGchLJrOkHj NN+KUgN6BRylL3mkbXE6HPIymhPLCaiX1et+b+3JsjBAz/AQcPmOp12myxuoYWVMuX0MnBPD4mKx 2s3fGJGmj5XBg2bCBHsw+aLlJ0yJ8KbK3C1T1hU7T7aA0lWAkNVpfFoDbncXjZUVHzToGb4bfJSO lBYQdW+V0WTL2CFHcTdAbdMxS4b4VqRe6UUngaz8CmaCx/Mdy9ug3IvsTJ4U8Bw22+Xpy2TY1HQB XC7SLn66jtZf71bTx0o2pJkw0Rlp1rKIGixH2VACrLNstYBg+Vl1OsHAoJcKwgzJirek/U4a9Iju CbvyBOcmIiUHRG/x3hqz7UnckwYUDNZuAQu3PJTtdB2BrNVvfNGJHQcIHV4jkExH5dPFG1QylQOn pRtx8geJZEMHoss9W50TOR/HU0FrneRQ5G9ml5ax6mapjShGHVNsTN3VurQqWz3zj8xYDAQ2INvx 6ZNcAEPkTDsoHtJ6CKC3IJ60K/dYPeDwdlSSIFZxY6ORdzY4BEAZp7nnd+5ZsQtYAsoR03EWtfjW ehRmbh2dkkDpOAVm+niQhL5f3tq1jLK8xq2KNkXbbg2etRwmSqWsuiirmNaUR4maSqdPXWgZLAa3 +/Kay8RluJbRru9UQ+ASMQVZnrJVaxnNGwFcGC0JZRyucRwIt9CYKJWlzKKSwMko45pJpISjwomA 3mMto1sT7UWKD2INN47WMg4wimvVMpKmo/mWePEgjiwmRNhkOJyOD3Pin5xKTelk6L0kXK/LS5WL Lv/th1bRSocKdNymrMNnnGbpauVI7XyRbbyhPCB8x8wYKK44ZjX8SQxyuqC72pZVLovMKfXOUWUP VpO/7ZWOqzga0VF3uoB66zJ3vSSXT4VvIXSJhYyAhd/vyno662E9f9RxTuZ/xdbMEjz7YUc0tYQ6 MmlrG9DvrzLich1zZGZUgW47Y0fEQ+T5mQ5Pekcv64//SRQLFvCWKeUzdzatlDY4g4YJ5zTjI6MF Rgv0ZQGWUDVlpX2NUtQvJHDfr4/wt8WKlMluhI4eRWswCJSXdK67yBYlo0GPv+GVIcX46GiBgVuA 1952+Y27fuwHB4DX70f3c3T96Ip7ZVXippZE0nmobPwzBEoe4z99EfrdVEK3EgAAAABJRU5ErkJg gk== . Conversely, they expect to receive the value of their claims with probability data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAcAAAAQCAIAAABV4/KnAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAHBJREFUKFO1kMsRgCAMRAO9eLGEFJR6qMO7aQZ7iZvwGUe8uqedx26AJDOj RXlFIH9RMlPBfNFuiEs1UhGthaFxAoxshDzh8kCjcD6gQ6+AAka5uSjFbSzC8ccxh579NgXK13nQ vr23MV87gzDpc5M3e7l3P3jssuIAAAAASUVORK5CYIJ= when Bank Alpha undertakes Project III, with the interest rate on debt still being data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABwAAAAQCAIAAACKrYi4AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAQBJREFUOE/VVLsVgzAMFJkFqDIBTACDQJsmG2QAXLJCBrA3YII8GrMLkfzF jqHg0USNhc86dGc9Z+u6wtVxu5qQ+GJSwdiy/59j1NURqegzF+07pkyiC6tVSS/ccdqyn+gp76pB 4pqOBCqHSlXYlQp5Bx03DKc8lfN0L3OAvLxPs6ReRd8CHxvTtiadHoU2oE45eoxi+cJen+FpKXFj qxnlgBcRu+FRykirka+VKxgD04BUOXPgr0cxswyO0tt8ylOAZtQ6xsIoD2zGTv29kQLdKHWiLzOF OmP89btjlGhSF3YqAtIf1JJuxiiYssjT3WlNAJH/pjdSmv3tg3LJo/UFZNis2oj4/ewAAAAASUVO RK5CYIJ= . Indeed, because the debtholders avoid monitoring and, therefore, have no inference on the undertaking of Project III, the interest rate remains unchanged. Hence, under Project III, the debtholders expect to receive data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAfYAAAAQCAIAAABr48rAAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAByJJREFUeF7tWz2W2jAQNjkLpODtCcgJdtOkot0OSmjSUdJtA2XoaLdKEzjB cgLeFjF32Yz+NdJIlmxDFrCLvI2R5+ebb0ayNO59fHwU3dUh0CHQIdAhcIsIfLlFpzqfOgQ6BDoE OgQYAlaJP62/9b6tTwiX/dq5wX4lb5Jw7qe93nRv/8SU8Mu6vZ/iMXmRoczOk+CNjjuY6L7jO/sv u1yEM0xN9jTRQhZKL0DSnrZ13TMTfJwvSYY4wdqmSs1cbs7D9Dw6R3ana8cja8KVpw42auAqV6Ni tCr537uJJSF6kz3FrslOSJGCrP8KcUqI+N36H1Im7yuhvlyuCz1tm61tx+q1ZRV/kF7rZ8hfq93H vrtYpJrmBoiEuqaFXoAcMnBmyEtDX1PXPTOBwNklRzodEO3JfKGi1pTMlVSxaGGyND2dPTyuLbvT A+jWWRKuiptIG4PeqnsmEnCzkPXDqpy7CSqjQhRxU1Vru2qDbL/C2gNwiRfDdxP4R/5g2Ur96ZLb hWE0GhEG2OQOTQCk19aDHiZp7nv+EtgqhMOWuxOjrMN2WNsKEJ6ErRjwXBXo1dZ1z0zw1jd1Szwi A5kvdNSak9l1wbXEyWUxJyhWV6azs/5DwsVE8cmzO6vE+6UPw2XSLR5NHxlTg4UMtlFz+vNajL/3 81b/RVG+Hx6+wlP9rw+H95Lv4Eyfit2vR1dQ//u4mL+g/Rox5PT3OBoOxN/92dvbrL//vRmtfgoJ jz8mxeY3e8zc7c8Wk8PrH76bhM2G5wGj7TjXi9rj09wP+p6j1w/Qaf1SbNFimpCXZiHD3goQ0gUB KiY/RDhgkF7P+8rSdN0zExycc+KPxqIAkfmSHjUtOC18FVRxchklbnU6x4Sz6nBb2e2XPlEP/XSr iKaPzOOvD1mDRcpCiQfOiFqtr8N84G8ckzdt8p3Wy6Mqz5jATNXxL97lF2V98QCqnjY03wdDUVOY k/YlJhTf7NpZIx6MO1jX/ZDvGcZ6nu6nz8XPmTsn17VQlm8RIKwLZm85y4pfVLmvwIrJoclwz0xA OJPhV1v0Ivn0hY5vIrRX+RKMWjzBc3PZoUo8l0F4PJ25dkOP683ulCAGSh8ZuOpohksJzNyjIdFR A7OAuMpVMR/Ik1DiJoSML7LlhLR/mT8sZoU8TvUOUOVC3zGHiYXXic2TPIYEmWqRjkfqOUgRJaNE Jg0lvdZPNnOf9j3JLGLQfrocbk2Blyc2zSxkM5x4E8MXSC2HS15sBu8LtTpopuuemRDCWaCuccWv /PB2G+IKnS901Foic9AFN5dFVc9O53aTRTp9wexODSIBFyOAn24V0QyXEb6p8jaLNU2yXZHCXX2b m+wvqM29ASvtJd+jGayfX8dwaFuujkuiFYe2Bqapya4cv7LZpD/bsnlFLGAGc5iD5D4O9RKQWiPN vArvC8ziaG8L6bVW1bb7ebaBGbA83sj1uvDm6agwEka2aiGY91xsxYQPpd5tB2pVF9/yu18mpLIZ jaPzpSJqZyMzjiDn4hnS2QEqL4Mum91VMbUJz8aSgUuNJlYGLXHLYcl2bBr1xasJC0q72KPxt/S0 Xl2sA3Ve7eWIvSV1CMyPCNirir74u4es+1UIulM4O/0xx62RxVGa4GT3IwabOT/RNoOP8ibiR7KF 4DBlJNvqVac07CWaXpIJtJJ13TMTAjhLvqW942NyEvmSEzUtLDl8cRf4IsPal81P52vP7uwgGrjI wNWJJtR3WJnJwgAl3tkfBRPlLgtbMMoMJ28qepzY2t3aOvAKZGhjzUg1h7fyYTByoIXCwetBnNda JrWwyW0ZSjlomnUbuN/CpmKKpw0sZLDq4xisi71o64NymFwLvl/WQNc9MwHhTC4iUt7xA2Sw84WM WitkjlAlkss8b6vSmQMS4mHakis86pLZnRJEO4es0kcGriKahNNQj98Xsr6f1lPVNGlWt3afhl7y kjflattaflKNhLgXCrf/WU2zrgFOc6M2INiDb8tCTaLWxibZ0ymbQg1WSoXpVqrvfmtNk15HpbRJ NmHWt5DohKNbbMkPJ9we1DgZwk2Tt8+ENpsmERlE6L2PURSfLYKollef6ipHsnKZfzOh9ZIRlI2A Xj5S6ew3TVpOXUN2ZzVNBuCy8ti0V/s33UZKHVHY6DQfsvC7I17ixadPtT8Zslu9ceFR+y3yoyqP 5UI574uvdeWaHS7xtdQLAkfcd/vZY63QcdtyPTX+xC2kQnIuXd707n0jcLtMIHCOkSFOx/oBistt gSr1I+h9FZldlP53dteoIQ3gStYmS7yotM63o8lCggN9kXqOqVvVPV1nMLu54z6caiYOfvpUrfQM ngZFtq3rnplwLWSorP/403I1vA2qXIyH1VmWNqINp9M0NR7VAwlNd7q65zsEOgQ6BDoEPiUCjTpq PqVHnVEdAh0CHQIdAhKBf2w7LN/m/PwlAAAAAElFTkSuQmCC .

194With insurance, the pooling interest rate is determined on the reduced support, which is data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAADEAAAAQCAIAAAAwDgDYAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAWJJREFUSEvNlsF1gzAMhqGz5PWUCZwJuHUKc+ypG3QAc6Qj5F4zQTNBXg6x d6GSsA024Cjkgi8RwXz6jX4pKfu+L3a23namB+WgJtucSlp1t6qwq7O3GScLhOUA858a6zXBp1AG ithWGbZQX7nbDFWBkAZVC8m19Ahm7ez9enw/MPKubgmEeZA+w9RkbseP195SIMyDx5qw3OQsCqjE tvn+ud6p1pyVIwRUjgmVNEoMfqJQarwWoqBAavqevzYTwE9ORRFrotzotqe1RKq3EEZNC34CE449 1tWuQTlF83teJMw12d/zZeyxqv37fNhvYKDpaNtAiE4812RuF+l6DIcpJqOhWjc0Wik5uTjMOHgt EfN5QlKEBT+N1tCSfGWMVgId6E2vpW8Kst/kIm0GFsG7OPb4IDQ1tlHS9aPL6zIM5/BtkutJHsGP 8ImmVSjtRaEOjUJAiXK/Aoze3EQod/hf5R8EcOGL8rRq1AAAAABJRU5ErkJggk== . Therefore, Bank Alpha’s shareholders solve the following maximization problem: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAPYAAAAQCAIAAACqbRUAAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABbtJREFUaEPVWr1y4jAQ1uVZIAXDEzhPENJQpc3MFaaE5rqU6dKYEs9ckTYV zZknCE/AUMS8C7erP0uyZEmWfcmpSIzYXe1Kq91v15DrmKPKs6LGBao8r9SFqoLNswHfwgCCusiz TKeMUE+uxnnqIiNxwoCDKxyxbDwpKkbygv79jX9xUTqpPcQL/iYcxsbjx3+xrQ7rb8iI4/J5Om6m P2AsTrMpW+iwop83dP5ue4Gpy+dsucT/21cymxNBGanYYfUye1tPIrk08suf9+P8NkmEc/nL9g4N ZxY/PBdZ+U7ertfdz9t5VqDek/XH9fqhPqSY8qW8k4fHrNwfvlSHZvFRXbw+z2nshmssPed+R+M2 i+J4ooTUhEyns9Piifx6IKdePgYXZ79k0hJGfT5mPS+YZ9XL9un8jOmK0k0mBHaGq3u/S9bbtjhe KXaf4gaGoFWqd05u5+T0Gb94jKoOA9v6j+jil+1LSe08vG6ObuUPq8XmXGMM+1jXnZROGSCiJOVC xMgOOgykYrQc4LAvieWCDXDokB5ochLufPnkuUqcE81td9stTXHcw1i+C3E4niEkKX5+ghzR5+5g CFru3beDreW7BNNZdjxD6Eof0jaZAmm+dxpo0f+bwLcx1GhjcWVGQl+1JDAgI6UhWeaD9BCcuzG/ m6CpHzDCgxQoR3iZ4pUqKxnKKDmHKCi6ZMB3/goHlJfwuz8WZ0ULq+KaZQMMVElGjOLpN3gMCQKJ TNZvhR5poHIwgjiFx9e3x1Q9ULJ9wDc8b8BTXu3uMd7zagDiUVc4FQIh92TFr3uAP+sdIjWU8PiQ CNkATZPNqx2v1Oewcik5jAO625Ci3oFtiO7WH+wpxEBV/xuReJRyiGdIJZHLbIFz4gM+M9I+mC/V bfrwt8vJsQEj0xIwvltdAFiQ9kG1+RJOEEjZBN1ZwF8SOdEJBAgc1NBCHRI20NCanmMHw0YbV0uX BgxIAIIVo7Y5Ejat9qXQqUM4IJU+J6TyIL7Nn1v1laUn0K3/DVwOSCol1HpQ39cFgd3aL2kj7/j+ hxYMIIB+KeYwtmEewlABlkAe6YP5UjegDz/4T45+1AwVenc6Yp/lAnhYnoDoJGIUq8Zhgj3QR3YG +yVk39PLHRyPLN/Z4TFEwIOduqiDS9cLiKbvjygB5as1YhOGwZcXJ4aflqRkexgkPGALXCSY+ozT spL69aeeK6Fk82gDPOocx6lqe9vA0wnmEUUU70KY0pRGq/GV5DWxuIoP6YHq0JuD4VZV4Gqv+xUT olySIwsQm5iWcq0Jz+LNpuiEqhxl4wy3cApX2dtYPGDrnADeMNCvfxAWF4lg2uqMdOGtyAPUyBWv FeHMEKdkjsCrBWGBZh422mkwNrc2immFYXBKk2k+MBag/hR0KwOzdneos3EpArCLJN5dkEpPBaJs QbTPN87AwR7hTsP8Z0pZA/rHAfr7XbzBKaKtq2CXiiz+FyCOMFcBkYsSq7tA70ons/TbKcgLV8H6 XqrdyTdAtJULLpfS9RP5sCIvTR/dwQdBDvbwsGLsHa/KklEfttbl6yNV4VaV4NVf+C3tV7ESQX+U 0/BFjq8usInGqASvfO3M3kB/l2EmS8VRrV0vHcjwRpWPidUo3U1D+/fm7w0822YTYsUJWia3cWkE 4tBlc46qoeMRgSvyilGL3euwe4imoQpnVL+K1F9FvQmuybu5kaeWsGAIqwtEu3h7Q2aPi9v7uL57 EWChy8Buw/2HFNB49mjX8sJhQ5/nZHX9h3FxlImx3f9KIODgBiOJdXHaJxo0C7FfnwmfoiHQ/PVV grWd9uF97WNMXz7dDm0nnZVjgu0MQVgMbE8P4+ISpfs3VWafAa+DQ2a0i0czBMQyRHb82tR11XRx /LG0Wzi1ecA9THI3k1nfyHFcPFjhgVw8eL2mjzb88Zi/2I332PQM7fPL4a2O3vrxGYyN/2IX/wvq eh2G3963oAAAAABJRU5ErkJggk== , whose solution data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAYAAAAQCAIAAAC6IZmZAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAG9JREFUKFNj/P//PwMqYELjA7l4hbanMzIyWk+8w8AANAsItqUxpG2D0oyY xkNV3Z5gBbUnbRvI+DsTrVVXhd0GqgfKXLkFVAU0x2oCSADEAhrJAKZhAGwF2F1QRf+3MbRAHIFs NEg7FkeQ6ke4tQB7+U5hIczAugAAAABJRU5ErkJggk== is given by the first order condition: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAI0AAAAQCAIAAACkxGtvAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA1xJREFUWEfVWT1y4jAUlvcsJgXDCZQTkDSp0tKZMmm2S5kDmBJmdme2paKJ fYLkBAwF5i6s9PT0a1mSMU4GFcaW35/ez6cnQ86poypo2cSIm5ISUpRw/cOvnAcmrZuYGP0eeAml tKj4ZFWwJyGMP4hJUylM4BC8SCy4BcMNDpJocyBKpjuapmLOwYAmRTaoX0rQkpqyUNmi4mQqNaIE lKYRNxynX5CfkVEvs93T50vuIzutFoc3leh5Tg6zCknn6w6emD75/nTcz+6YVvnL7j62hM/AmEzJ 8cR+LaWK92O73y4y0/DTkUwnqbq/je60us/uV3wd1mA+z5a1norXE2KNCSAWtlhwqPKdVxl/A9y0 LAGwEHakxCgKtQidEsUCMYsMYJALlrzKvO5qEogQtSbuKpMCYcbAaTDN8ZYCH2RFd4kNhj1I8lTc 67KRiepYn3Yp182ItDe7mSKuaCOpsRTJ64sHd1ooDhjbfpEIUIstU2yGhmzbfjdqPC7Ao/2jSAbG qXv92jq8s13h8W/MSRdHNyYYPJPQJCXIESQSS1wGO4NaYfLJlw4eGCcsFY8GhSUyPgKHWL74UA/m FFpd02ch5ypLCo0KAUvUBmDvJC1ru53i4qJT4hoq9QuM5mhxSk4+BAZuD+XgdG0ICiC2bkwRo0D3 UEtiGIsGuWS6CK1CQzIWp0iaOH2Ivey01EmJmU/SGD2X3sXUHu0A0MA1dYGe6wQnTnojsPUjGevL 52uvH2VP7bxM8R3vKa2mMs7EWm9a/p7bhCnx7UuDGurdhj4/QofPe328hUefJcAFy2oPT1MNp4le g9lDvl4nXPoDqc5r0xOUnSaSzk9BjVyKMyZTBh+WqpjNzFdf/RcXk5ryvl5OXrnqeilOKwFLIgmN 2vK7Gdns8OTDQmsegkyD8sdnuofzHw65z1XkXR+nlDl987GFe552t3/3NGYv51+h7mZUxwOE17DE 3EkCPZGFfL4ewjhwDesj/K3lNZY6LH1uhTvSchjuvRT3BEw0B4Hs/NtHtlzB9e/qfUOsgk6Bn4to LtgHL9IzGlP+8nl+2mVd340W5J/68hZPPVXFBsJhlcqivvLn17hN4jRZssP7d7XxaTaNRpWOe+GP zT/wKVrkivrLw0md0Tz2M4L/A7OWO4elnXr1AAAAAElFTkSuQmCC . It is simple to verify that since data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAG0AAAAQCAIAAACTJmYeAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAaVJREFUWEftVjFywyAQhLxFTpHxC+QXuMsP0uHSVf6BS5f+BP5IxoXRX8gd ElgKQkjicBNfYd+M0O7tcqDjxhj2imwH3rIRXgDoQNTH64HzwxVWhAmVcx6ZCjDEKa3C40/0Yy2/ 97ayMKES7pGpAEOc0io6/JiPzf1n+15BWWFCpdkjUwGGOKVVPCTEfNS37aftxjChku2R1wA2px3f nZrEq6VV9CQYowRUI1SX1FIbo2UNp3k0ge/78piiWIhmofCuger6UVpFQgKTtVBgGwR4CQkaShsW NJui889ueBA0FHHZaXyGL2ON6/xz6v6cr6BbMihm11daxSQ++oi94o+JEqEJ+f2ZT9HtWHy7BxT5 FY/1/IQz4CNehuu6cXa1dBTR401HMa4qgQ8+QmnORrcY/5mQ+Ns+i93uM52kp8CCBu3Ro5hZ1LJl CXx7Pz5CCWub1qr9YrsPD+FpfwLFModIVg/nx+bOPjbQg1XFbkxejpUbkPbnC/uaMbClR8EnUKSL KLBifAjTUrjxEdpStjMbyS3q57ByFCQNthCEw/oCu/PvIH8B1B8+E5zsjY0AAAAASUVORK5CYIJ= , then data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAACIAAAAQCAIAAAD8lzozAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAANpJREFUOE+9VMsRwiAQXazFpIikgtw8WUJytAkLCEdb8OQJKrCJkF5wF9DB DJAMGt4lDIH3YReY1hr2x2F/CVIoLiMHxljL57/Gk9wRYm0QoodeeF87+yOQlNCMSrOMFph5W93P 6nk5ppNLKWGaoK6rDqxjNTZuiwkVgWcvtCJBQjL0m5KZkR18w9Hbc40gTYIySOK4iW5JFZoLKKVJ NJDKBxG7bkkizBqJuTfvgxJwDTZ0dzP+Tw9secQgQ6VPk2wtv3dQZH1ZwpUeymnojAtc/LHJ8Lh9 S6E0L7KlEwguWzDQAAAAAElFTkSuQmCC . In particular, in the case of full insurance, since data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAEkAAAAQCAIAAADVkMW0AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAZNJREFUSEvdVztygzAQFTkLTpHhBPgE7nIDd6K0G3cpcwBRxpPGbao0gRv4 BB4KpLsQ7VoSHwFD8IaCLexlWN7u03tIQ1BVFVtpPK2UF9Aa5JYnQZDkusJPqJbDIVMBdnBGdIvF aYfVfkI1jEMmAVTpNsDYpmpMN1XeoudQV/gJyRxNZBrAPNkco0xvH1Kw4x7YDekmi+gVVfMTmlEa yCSA+ffZuCA8vPHr148CbmB7fLUwQT1V+n6+lb3JrEHGWkwAxMf9MNZDAG2vFtC1kIyJmGdSxDoY JhxkJQ0E/d8WYESY38xtLhhcZpzVN/7EC57siVjIDsz8FtPmATqua4MbrKkbJuP+YNPgx6oeazFl BXWNG9zkWreWnI/T6ENYoEVtPieh5qZZWqfaGeCfcQG/93tm5eZKukCLekj3fuH7VkfGkYqU2d2/ dnMhdOoCLQyf9vmmSvay0VqFISuYuBxCe7rtPi5sb8/7Cbv2cMkCLVzzjmzGhFJw2F3Qm7EQZjek OB/Q3QDUbvFJ2MJSClb8jfMLDpmNSWT1qP4AAAAASUVORK5CYIJ= , the shareholders have no incentive to signal.

195 See supra Part II.D.1.

196 See, e.g., Andrea Beltratti & René M. Stulz, Why Did Some Banks Perform Better During the Credit Crisis? A Cross-Country Study of the Impact of Governance and Regulation 2 (European Corporate Governance Inst., Finance Working Paper No. 254/2009, 2009), available at http://ssrn.com/abstract_id=1433502 (“[T]he banks in the worst quartile of performance during the crisis [2007–2008] had an average return of -87.44% . . . but an average return of 33.07% in 2006.”).

197 See Ing-Haw Cheng, Harrison Hong & Jose A. Scheinkman, Yesterday’s Heroes: Compensation and Creative Risk-Taking 4 (Nat’l Bureau of Econ. Research, Working Paper No. 16176, 2010), available at http://www.nber.org/papers/w16176 (suggesting that the banks tarred today because of the aggressive use of equity compensation were “yesterday’s heroes”).

198 See Gilles Bénéplanc & Jean-Charles Rochet, Risk Management in Turbulent Times 7 (2011) (describing risk management functions as decisions on: (i) “[h]ow much risk to take”; (ii) “[h]ow much of this risk to retain and how much to insure or transfer to financial or insurance markets”; (iii) how much capital to keep as a buffer against the potential losses arising from retained risk; and (iv) “[h]ow much liquid reserves to maintain”). Apart from the first decision, which relates to the acquisition of an asset, the other risk management decisions are designed to modify the risk the asset’s holder bears. To this extent, asset risk depends on the risk management policy of the asset’s holder.

199Consistently, empirical findings show that before the crisis banks with stronger risk control invested less in securitization operations, despite the higher profits. Andrew Ellul & Vijay Yerramilli, Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies, 68 J. Fin. (forthcoming 2013) (manuscript at 4), available at http://ssrn.com/abstract=1550361.

200See supra notes 95, 108.

201Several policy reports have attributed the lack of true directors’ independence to the widespread practice of vesting CEOs with the position of board chairman. See, e.g., Basel Principles for Governance, supra note 20, at 18–20 (highlighting the importance of measures designed to constrain the potential negative influence of dual-hatting practices).

202This argument is also supported by empirical evidence finding that shareholders at financial institutions with more independent directors suffered larger losses because independent board members encouraged their banks to raise more equity capital. See David H. Erkens et al., Corporate Governance in the 2007–2008 Financial Crisis: Evidence from Financial Institutions Worldwide, 18 J. Corp. Fin. 389, 390 (2012) (investigating a sample of banks in thirty countries from January 2007 to September 2008). Indeed, while the actions of independent directors promoted banking stability, they transferred wealth from the shareholders to the debtholders. Id. This is consistent with the idea that opportunistic shareholders will tend to dislike truly independent directors.

203 See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 951–57, 124 Stat. 1376, 1899–1907 (2010) (codified in scattered sections of 12 U.S.C. and 15 U.S.C.). The governance provisions introduced by the Dodd-Frank Act affect all public companies in the United States, not just banks and other financial companies. Among others, these provisions include non-binding shareholder votes (i.e., say-on-pay), measures on the independence of compensation committees, compensation limits, and clawback provisions. Id. In addition, Subtitle G of Title IX of the Dodd-Frank Act, which is titled “Strengthening Corporate Governance,” includes a limited number of provisions about shareholders’ access to proxy materials and disclosure obligations for companies that combine the CEO and board chairman position. See id. §§ 971, 972, 124 Stat. at 1915.

204 See Sepe, supra note 36, at 229–31 (discussing features of shareholders’ empowerment introduced by Dodd-Frank).

205 See id. at 225–27 (arguing that Dodd-Frank’s failure to consider simultaneity issues in executive compensation design has the potential to exacerbate, rather than improve, compensation practices).

206 See infra text accompanying notes 231–32.

207For a recent scholarly treatment of financial self-regulation, see Saule T. Omarova, Wall Street as Community of Fate: Toward Financial Industry Self-Regulation, 159 U. Pa. L. Rev. 411, 413 (2011), which suggested that a policy of selective intervention designed to exclude systemic institutions’ access to safety nets would be beneficial to promote effective industry self-regulation. Self-regulation advocates also suggest that empowering private monitoring of banks would mitigate the informational asymmetry problems that affect regulatory action. Therefore, it would also reduce regulatory arbitrage, which occurs when regulated subjects employ “a perfectly legal planning technique . . . . [that] exploits the gap between the economic substance of a transaction and its legal or regulatory treatment.” Victor Fleischer, Regulatory Arbitrage, 89 Tex. L. Rev. 227, 229 (2010).

208Since the crisis began, 490 banks have failed, as compared to the 26 bank failures that were registered between 2000 and 2007. See Failed Bank List, Fed. Deposit Ins. Corp., http://www.fdic.gov/bank/individual/failed/banklist.html (last updated Oct. 11, 2012). While these figures are significant, they are not even comparable to those experienced during the 1933 banking crisis, before the adoption of deposit insurance. Indeed, about 9,000 banks failed between 1930 and 1933. See The First Fifty Years, Fed. Deposit Ins. Corp., http://www.fdic.gov/bank/analytical/firstfifty/chapter3.html (last updated July 24, 2006).

209 See supra Part I.B.

210 See supra text accompanying notes 183–85.

211 See Narayana Kocherlakota, Taxing Risk and the Optimal Regulation of Financial Institutions 2 (May 2010) (unpublished manuscript), available at http://www.minneapolisfed.org/pubs/eppapers/10-3/eppaper10-3_taxrisk.pdf (“[N]o matter how well-written or how well-intentioned the legislation may be . . . . no legislation can completely eliminate bailouts.”).

212Before the enactment of the Dodd-Frank Act, President Barack Obama expressly stated that this was a central intention of his administration. See David M. Herszenhorn & Sheryl Gay Stolberg, White House and Democrats Join to Press Case on Financial Controls, N.Y. Times, Apr. 15, 2010, at B1 (“‘I am absolutely confident that the bill that emerges is going to be a bill that prevents bailouts. That’s the goal,’ Mr. Obama said . . . .”).

213The preamble of the Dodd-Frank Act lists the need “to end ‘too big to fail’, [and] to protect the American taxpayer by ending bailouts” among its core purposes. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).

214This type of time inconsistency was first informally discussed by Kydland and Prescott in the context of government investment in flood control. See Finn E. Kydland & Edward C. Prescott, Rules Rather Than Discretion: The Inconsistency of Optimal Plans, 85 J. Pol. Econ. 473, 473 (1977). Recent economic research has looked at the time-inconsistency problem affecting the regulatory enforcement of anti-bailout policies. See, e.g., Viral V. Acharya & Tanju Yorulmazer, Too Many to Fail—An Analysis of Time-Inconsistency in Bank Closure Policies, 16 J. Fin. Intermediation 1, 1 (2007); V.V. Chari & Patrick J. Kehoe, Bailouts, Time Inconsistency and Optimal Regulation (Nov. 2009) (unpublished manuscript), available at http://www.econ.yale.edu/seminars/macro/mac10/chari-100216.pdf; see also Macey & Holdcroft, supra note 2, at 1403–08 (suggesting the adoption of a “Bright-Line Limit” to avoid banks becoming too big as a solution to the limited commitment problem underlying anti-bailout policies).

215 See Macey & Holdcroft, supra note 2, at 1370.

216The failure of regulatory initiatives aimed at limiting the use of safety nets is often attributed to political self-interest and regulatory capture. See Frederic S. Mishkin, How Big a Problem is Too Big to Fail? A Review of Gary Stern and Ron Feldman’s Too Big to Fail: The Hazards of Bank Bailouts, 44 J. Econ. Literature 988, 992–94 (2006). But there is a more radical explanation for the ineffectiveness of these initiatives: safety nets, despite their flaws, are ex post efficient to prevent bank failures from damaging the economy as a whole. See Adam J. Levitin, In Defense of Bailouts, 99 Geo. L.J. 435, 439, 451–53 (2011) (suggesting that for too-big-to-fail financial institutions—defined as those financial institutions whose “failure might trigger socially unacceptable macroeconomic consequences”—bailouts are inevitable). In this respect, while the Dodd-Frank Act subjects the ability of both the Federal Reserve and the FDIC to rescue troubled financial organizations to stricter tests, see Dodd-Frank Wall Street Reform and Consumer Protection Act §§ 1101, 1104–05, the risk is that regulatory discretion might be reintroduced upon a future financial crisis.

217For a general discussion of the basic principles of the prudential regulation of banks in the United States, see Richard Scott Carnell, Jonathan R. Macey & Geoffrey P. Miller, The Law of Banking and Financial Institutions (2009), and Lissa L. Broome & Jerry W. Markham, Regulation of Bank Financial Service Activities (2d ed. 2001).

218 See supra note 183 and accompanying text.

219 See Acharya, supra note 70, at 225 (“It is thus broadly understood that the goal of prudential regulation should be to ensure the financial stability of the system as a whole, i.e., of an institution not only individually but also as a part of the overall financial system.”).

220Contractarianism, as a general approach to institutions, assumes that legal norms “find legitimacy, when they do, in their ability to secure (under the appropriate conditions) the agreement of those to whom they apply.” Geoffrey Sayre-McCord, Contractarianism, in The Blackwell Guide to Ethical Theory 247, 247 (Hugh LaFollette ed., 2000) (providing an excellent discussion of contractarianism in contemporary moral and political thought). Modern contractarianism finds its roots in the monumental contribution of John Rawls, A Theory of Justice (1971).

221For a discussion of the differences between this Article’s substitution hypothesis and the representation hypothesis articulated by economists Mathias Dewatripont and Jean Tirole, see supra note 12.

222 See Dewatripont & Tirole, supra note 12, at 87.

223 See infra notes 254–55 and accompanying text (discussing examination ratings).

224 See infra note 257 and accompanying text (discussing the mechanics of deposit insurance premiums).

225U.S. bank capital regulation is largely based on the guidelines issued by the Basel Committee in 1988 (known as Basel I). See Basel Comm. on Banking Supervision, International Convergence of Capital Measures and Capital Standards (1988), available at http://www.bis.org/publ/bcbs04a.pdf. As embraced by U.S. regulation, these guidelines provide for a risk-weighting system of capital ratios, based on the assignment of assets to risk buckets, each associated with a different risk weight. Under this system, a bank is deemed adequately capitalized if its ratio of capital to risk-weighted assets exceeds an 8% threshold—with eligible capital being defined on a consolidated basis as primarily consisting of common equity; preferred stock and other hybrid instruments; subordinated debt; and disclosed and undisclosed bank reserves. See 12 C.F.R. § 225 (2012). In 2004, the Basel Committee enacted a new set of rules (known as Basel II), introducing an additional methodology for risk computation in large banks (i.e., the “advanced approach”). Under this novel approach, banks can opt for an alternative system based on internal risk management models and rating agencies’ credit assessments. See Basel Principles for Governance, supra note 20. In the United States, the advanced approach was introduced in November 2007, with applicability limited to large banks. See Bd. of Governors of the Fed. Reserve, Interagency Statement—U.S. Implementation of Basel II Advanced Approaches Framework (2008), available at http://www.federalreserve.gov/boarddocs/srletters/2008/SR0804a1.pdf. In the wake of the crisis, Basel II has undergone intense criticism for giving too much leeway to banks in effectively setting their own capital requirements. See, e.g., Kimberly D. Krawiec, The Return of the Rogue, 51 Ariz. L. Rev. 127, 144–49 (2009).

226 See David Gauthier, Political Contractarianism, 5 J. Pol. Phil. 132, 133 (1997) (“The contractarian position is . . . constructivist. That is, the entire normative structure of a society is conceived by the contractarian to depend on the deliberative normativity of its individual members. Each from her own deliberative stance must judge the social norms . . . as ones to which it would make sense for her to agree . . . .”).

227The standard reference is Daesik Kim & Anthony M. Santomero, Risk in Banking and Capital Regulation, 43 J. Fin. 1219 (1988). For a more recent contribution, see Anat R. Admati et al., Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive 16 (Rock Ctr. for Corp. Governance at Stanford Univ., Working Paper No. 86, 2011), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1669704.

228 See, e.g., Viral V. Acharya et al., Capital, Contingent Capital, and Liquidity Requirements, in Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance 143–81 (Viral V. Acharya et al. eds., 2011) (suggesting raising banks’ capital ratios and liquidity ratios); Admati et al., supra note 231, at 2 (arguing that “better capitalized banks are less inclined to make excessively risky investments that benefit shareholders and managers at the expense of debt holders or the government”).

229Full insurance implies that all of Bank Alpha’s depositors will be fully reimbursed with probability 1 in the event of bank failure. See supra note 187. Accordingly, since data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAB8AAAAQCAIAAABhmjO7AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAL9JREFUOE9j/P//PwPNABPNTAYZPMRM357OyJi+HRoiVHT7nYnWjIyMLVes EIFNRdNV8o8Ck8jCMKSYBJoO8gsasJ54B0kNFgUg9aiKsKeObWlp2/7fnmAFJP+DaKsJt4EM8gHQ CAawWSDA5Dlzpuedrat0AjwZGIA0Q5i3CvUSKTjcb19j0FIF08d01DANpyBkgO7flgbxC4QGBxX5 ACVkGEBmQgMKJAFjk2M8RD8MgNzIOFrO4EhmVMyrWGwAAHgrEX44t0y2AAAAAElFTkSuQmCC , data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAEIAAAAQCAIAAAAtcD5DAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAUBJREFUSEvtVjGygjAQXTwLWjicIP8Edt7ALpTa2P3yHyC2HsHKRrgBJ3Ao DHfB3f2ZKAaUkR1ndNxqCezb9/I2QFTXNbx/jN5fAinolJGnUZTmYiIJ7mdTAYSJSA8cqtbItDK2 6+YT6x4vTJ5As0b9q3cku9yoTsdkEotslDxIno5XSYbqrYHVgjzukmHLZD6TJyCCmO+3yqyJXbz8 1cXuUJEMmlY+BpzwAFebv+3xhEkz+IEwuOQqWgABW3O/liSsvd8CB6VRUpQWwCid4aRhACeazBoQ DCEJGHChc+FZugugpzINlxsDJPhSccBrUsTcv36cDDob6JKbtQej23Oo+gOG/Xq0iCfJpc6WhZqO Ad1omCThhTjgLSlvtjcGZeDi0APR7CMOGO4tCeFwzKPvP5XIR0AG5NN/DWV26VUoZ89y5WpXS3Lp AAAAAElFTkSuQmCC always holds and therefore the outstanding debt is always data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAAkAAAAQCAIAAABLKsIUAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAI5JREFUKFNj/P//PwMOwIRLAiiOT44BaOb//9vSkLVbTbgNFoXI/b89wYoh bRucyQCWRphppaUK1qySv3CC1bFrt2H23dm66piOmgqSwVdu3YG65fa1Y2kBnsh2glSCzdy+YRbM RCAPZAiEC3EIzGlQN0OcBZID+gDqRohnYBwGkOuRAEwcpI+RBuGJL6wBm8JvTpOqPlsAAAAASUVO RK5CYIJ= .

230Formally, with the new equity injection, the shareholders’ expected payoff becomes data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAANIAAAAQCAIAAADs27aqAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA4lJREFUaEPtWTt64jAQnnAWh8IfJ3BOAG6oaLcTpWm2o0xHY0ro0m5FE3yC cAI+ith3YUeWZT38kGSc/WCxqmCP5/Hr18xo8nJN47cNLADCXeTBsG5GINsOeBpBHIEXfe1Co9wg YIvAgKcFUqMmGTy0L/laJpIIffq2zSwU9yqSLDU/etVep4xapKu3YJ8cT8RYgfSKVTbIgQ/i9CoW PlUf5HLKoyMBIEfpG8c/qUL9e6pTWaVFfFOxXnrNY+jgjmpRN6FhYBPhY+MpI8gicYfADCk0AanT Tvld+BNUaSOpQ+OtLGDO6SIKF9OYSGdBc0k9BnUctiEJO3aFF3lcAmad6bI+U3S67UfAkxAi5Zqu pMPIjZA2Flkt6WSff2AR8jsH9i+o/AMvIt1XcjjHxzjYH+QiztKu/1qo9SL5nuOFC1htSvH0cgqE S/iLzKcd3eEWvegjDk6XtKMah8/uEk/wfRFCsrkssOIJhB2ikzaxHlJL2iFKp8m4z5tucoB1NA0X Gu+EoWSpdJU0aORdcP4uOsvs+wzCpeSwF2x1AqgaWmnCSY+T8F3iCX44nhSHLlm++3PouOlmSC1p 54SphXC2fQeamyiRlHyHSQv2M9rMz85l0pMV8lxEQyskc+l913NZTZP9ni8LNG4X6QVPGHuvfn6u s+3B/4gAy0ntHpj8NUM6Yhe2cpk0Gt/z+wplgkQL9UaInJmwiqjxjiYt1s0dSfvu0xIr+j7stFRx 4YYSXvViqqZJSuY2qM3RPS6exY4ApNtfl3nkUWS0EmuHqgWkI631NdLKJDDdcY1K0/0lz6IF65B3 4wmU+U4qnNPdrrZTK0ihYoK/tMZOuKEEqLhBQ0GLErbJZnUi65axuTm6h8UzLy64G6fV7LJG7NUm hm27Fao2kFoWWaWrMjHP9B43tzxZGMqcAO+m5OyMgy69uRM9Q1+NHaBFnibxKM/25FjPdlNMju/v DU88twwGrLJB/BsPvCnvNwdsBanDAEUadvDZFDNePydpGjFURnOogdZLVWfxUHavnEFwDcxu8ct9 vKRbrITxwwOUe8NTir/zHFTbxCZIred2yjDGaiDmOtkyKK3Or628uEXoJ2n3jHiyHEHzQxvtalIZ zSwd0sote88T2r81yxNqb1bLNKAkgKfBU1SlgnZlzevwj6Vb6fQ/fj/gabGrI347qeu4HPvkQVy6 7Q14ttHhL3Zn1Dt8YRaJAAAAAElFTkSuQmCC under Project I and data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAVUAAAAQCAIAAAApjHsSAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABXxJREFUeF7tWzua2jAQFjmLdws+TkBOADRUtNuZEpp0W25HAyV0tKlogk8Q TsBHEbgLmZFkWy+jkewlZoMqr5FG8/hnNJrxdq7XK4NxWX1/Y9vfs0Q8L9iEsdGa/3nHoXJxx22/ 9FbtsOwdVPwET4SSv4k12WLOJiPp7cns93oUQav+kmT23psvsvqEnhRyDbTEsncwyBM8EUoW/p/t Nun75x/22bTTmaJ32w8564NxutnpAQDieocPvjQf+Pb76hIhcq0lBee1qJAX43Y4oiVtj2XJMrsm EpADy57gcejOAyHI/6/7lPWXZ3wS47zsc0Lay/Ln6Kd9KinaD9re6V7dArgxGEH+tFcgANMXhfGI BM31SFMbxY6muuRM8Xuuu1B29O1M6WIt0SbLBpikUEYuNwU5UvmPCR6VawGhcJPHQIg5teY1FWwV CnDuGmKR/aBsaLm7+UL7W+qqb/uvQtLHrVCcKZAWFM7LVImQBkt6PHIFE69CReCQLHChSvubTmwQ uyFdJCsEbvUpNMsSyZbBvGCfTP8hwZOmqXLCxXq/7shUCGH+fz4d+t2XWvkZafH51BsPcKb9oK8/ nM7VBC+/fpalCga1ChB8C9XK+JHtjsv9sm/eOzAGF2pJZmoxNBlNmFKnQAUW1RNUZyrkDB35dsls u+zfVAKRcuss6+f7svrYpPt1rj+hEjJyYO7jgYd1u6VessVpAglvCSe/ytQZoRAC/7/8ObLea5OV fvXKAc/i3o6GPf6BC7v9oImYvPYYn+ce4P6HhrndsffZYDQxAkC5UTbVKg/IFwSAfsGkrkC4ccdE U1uuG0ogYqJlliVxXUbPbPoy72FViooctMsDgod1R689GbWy6Ud3zCIRHgMhWf8nmYY2CRx+eBRX 4clpMf1gMpjjSc37i/YDjfDnzAJwMTyt0aO1DACAyDZDLL4Nj87sKD9oUO1yJp+9iQredtbQbJRr QHv3sKyInrzkuxtfrzwPaClyxJlWHzzsNXnp8tPkstp1tzMWm47HQMjh/6LiXAwFOPm5jiBXEK8V p9GAy63sJRw37L1I5RpAYBAJCrcMnFdeSowAwOXgNdF9etsTMckuawNwe9Wnl2xoajUq+nrWgCHF k0SQpDP0VWFZGofYJKpjWdIukLFg9ESP37NhdNcjCCfOyST1NgIeCT+45KzeTuNZgmo2sn+S6rh9 yoOKACEU3OH/RplGUc9gnf+m1ZzEV0NiKNzjRX35I+oiXN9+QIHAreL+IncsMgAldR6s3SFMKlu3 F/bb9Mt/yYamWFVp/A6mGB169gdfP5YinanGCsuSOKxtWdIuEEvz6AlnYhMlkEgoUdRbun8N8PDc EqB3mA9PeFa67mwk1YVDSPH/+ndNU8/Z9O0nvrusVo1+z6PdvCONW0arxbwIv7x9XFQe1FwKslGz AFBetRq5/GPNMMc9ZtlqBaymjI9jWXl6yCMMY2BMHeWmutoGHjgthNkh2PX5WUk8th1SRkKIJ7jB zcbqnlPehIRWFn8MbmNaPStH/0/p1eX9dqERd1OyilurxS/51Wk6hChYUqQVisQRKrKxnSVDfP8v wrLVTbralvX2/1Ct0AuT4A5vMGtNVLHbA4BHkTP245Hiq5Mq1VUC4Z79f6/9+QSLVaunq7bKSTR9 /X8SkXKSzVAggcDp8f5/r/5/oEBV04uvfKLpPcHjVt1N/w/2p2jzEBa6vd0+3PE0Cj1oCdv7ptx5 2/zMjZX0oQJA8ZWPzwiVvz/BY6vmNoTw/DezpCItjsnAom3nztdqkvvvl+se8S8t6zVF/bSqPgUv k19tgqj/6/86JcuNrttxzWKUd7n+cZ93+nOCTwOtsayPUd7m15si/iX6jCd4QjXG2F/iS9LrxcJz 3gAAAABJRU5ErkJggk== under Project III.

231The amount data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAPYAAAAQCAIAAACqbRUAAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAABKVJREFUaEPtWTGW4jAMNXMWhoLHCTInABoq2ulCCc12U05HE0roaKeiWXKC 4QQ8ioG7sJLt2JYdEjthwlteXIXElr6/ZEkWnev1ytrRMvC8DLw879banbUMIAMlLp7OOp1ZCvPc B3h5Wb11+OBTsoFv31aXpvlVCG3FzeKxYOBPHPck5D8yiuk5TToEoR0KlYKxj6PkjN/dB3h5TiL5 ORMBbxh5tY8Zi/fFSoq+okB7PcokQ2mELxQQxSMXiin4CUcFdFKOuVJIU2Q5JFg8hRCitpvJeLhR JHvV7VJGYAA91Bls38PfrFAaGE7sw32Qb4lM4vLS6JHrooZKAFjoYmID9hTi9+ckFqeQDxtCkcfn HR8/ckFnHBvHmzi4y4xz8vy0iNCSbV+h/XWjCLW/aBc0UwmB/gwZVuRm0BaXtBcXKufTYDJEJ3Mf ctLO5e8Xm4678kt3/g04t9M6+SndHZN9Em12ZiHEBUb9V6VnPc90MtYdT9liKaZTPGIbh0gjhF+x 2F7oOJ9Yv68XpcvTFBKalkxghAo35l9Wn5t4v84wik0/2igAoZ5d+B5KCAwiLXOG7nybRIfTmS6W Lm7WLvAsamsk+PgDRbX7kIcAPOow6GlvC0KZOzndsY/5cDy1fFwrSmfkFoBCwMcjDho93MJz+Tky jTDdbfRBCQJ7+WH9cW8gyUxnn/0Js3RpGEGSrcn6EKaz18XgA87yw43CPbyOXdA05QT60uZaWVhf D3Rx8OnRUdSn09Ny9slk3MA4/I0R0n3wBVBnHhiTYZBFbyFxHAzPNiO8xI2OKpibmpyDLD4iG3Ih X7wx424AUswOve5rnx+ly2rX384ZpAcHyg0Y/prEIeSX+t3keuXR/MFGEZGvpl18CfRhyk3FdpgF F0cik61M9scN+1CJ0UdFlTlZzkA3M3yOdh2AB1klWT7O8co7cFDWwDJFl+1QqdHVGpVogsjh9kJU pQAJd/V+msy7CMkoU8o58dIFSQelolPv2eiePZkbAJuySzmBXvzgLmgqxiDmhJoXPkmaB09X8qdS dVpuVWPGcJ3dJsi1hmeMbGgPh8jVGzAVx41qY7jOP4359Qf1Q/hlFeIaFbnrEFSCVZ47ANRhMTph QKAFkNpCQRnkpQuOZHYIIWXUzgnlJmrILh4EevGDGUVEAbm1dLk4xFjNkWFcN9PZ+xfP56uVc7sr p8esgn1ml8wBtDKG48ThJGZZiWVmJsjhdjGuazOrHL5XIQ5nQzgeuF3EA0Je7LjDxcQIUGi7aveG +9wJtLHuYBc/Av18yIgCWG6bd3MtQPSlcECXiD/6t3DtvjjtwmWNZyU9pxF0qznltL4lLiozB6zT t5S9L2OTshUXtFMF3e3o5vbXKTOVmoYoAjqT0lL+3fv6RiloGta3iyeBPk1DyxkciiTtxX3xEkX5 f/34W6O8/+qzU2OOA6h66ztQM5luw6jk4uoPnkAk9Y3i0RevjSlQQKXpd3LxnBCN59Q/E1QCn7fo ptpm8VjasrAXTIj6gyeUIBXbSKhplgQT80M0m7R3AI1f2dPOapIBuGW8s61z1W0SwrPoal38WSzZ 7uMGA/8AEHvYJ/pG3foAAAAASUVORK5CYIJ= that the shareholders would get by switching to Project III is no longer positive when data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAKAAAAAQCAIAAAAeZ+MPAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA2lJREFUWEftWb1y4jAQFvcsNoXHT2CeANJQpb2ZK0xJGror06WxSzJzN0NL 5Qb7CXJPwLjAfheyqz9LSLYRDnMJREUiZGm/1X7a1XpNjjfXqiQi0OIkieI/2I+S6kgHtQ7uO4/j nO8/j/GpPmY3DSyCBuuqJI4iRYDsGutgJgqnGKYmckSqogq1YVkUU/TnG2Hb+4G2uKVWpy9kgzyR Ldmsfy3fjse3pUc8o6Nvuj7s/z35I2izfeCzZ8UCf/M2SWs2Wh+C+Rz/A1AQEjG5c8luS8Ykncz2 jw+eqYkcMXhowbIoBvqHY89C5K0RXKMtYaNFhsbsO7l+QA6Mt6oMqS+DN0lDTdeKp+ApYTMJ8f1g P/tJVg+ksWp9QK5blpTwDGjMw+2OH5MuzRSt7FgWFNB/PqWnstk4U0nuAQPFaZDJ4xNFpPe7B3Y3 +XnCAqZz4ypHEQ/JPQJYkEbd6NZwdXukpQG8maD3uwJ0xC+HTtGKpkyrNixzS/xWQrIaCCZEEswM c6qBxgq/SZxtThe4yBckXcixm4IANuDYcq/vOhVgQ8wH3FAGatXwJgjGOzo3fRgmtu/eRQkn+Tm0 JIE/lzmxG8FXny3Tn6sj2QA4wU2k0ny4OQhKvqmKEbGhzwcula9iGfcFuz76oP+LWT8PKCUYg4hI MbRgo9i0246CaPslM1z+5zHYV9MECZb2Z9mGek0L/2hxYGO3eCKMo/CB8nvN25c3399zjV89c7Pl vW0WFtUFUTdQ5in8Xi5fpmkGQ98huvPUE0xv1cCqZE7qE40lLaHvuwmHye912e8J3RYgttRFlvRU dzE9pfelsXk90v3uTPnX4o5uWbxo6p0PhzSxRCw69514oEpNoWOgoC+0XM35ZHJp1HislZYK3t6c dmpi6UkPFXZxVYdlyJ0q3VqpsjWJovVbVlCusHLI6pOnHbYc52ZjUZtURXrLccalnJeuWSHkYCfW eQBQZe9U6T4IrtNJNofT/rt8KaBa+8rKzWaH83sIquMaK7vINP/KACJGo0WB1eYN2RVnWt8KIQcR QcMC+fARgwG1NFeV7oLgelc+rqZA13Ow8tPnV7KHTwy10eEmLbKy+S4Tx2EJnxfg09EWbmvKOvHG ZdZKAOUHGErTyeKvDULi0lihYkUJKAnSQwFk59hNpXdsT3ro9PgwsgAAAABJRU5ErkJggk== . The latter condition requires that data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAHgAAAAQCAIAAABSoSyyAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAtlJREFUWEftVz16ozAQFXsWnILPJyAnSNxQuXUHpd2kS5nODZRx5zaVm4UT hBPwURjuQmb0AxLCSGLXqTzVBI9Gb55mnhSv6zrysPsz8Of+Wzx2QAbmiC4Sz0sKCNIdhbw2e/ae s9ZAaJ/kHsRbQbXD+b/gjesF6eCWx3yPMG3opzzmnu70i5o0JCIeV9AUcT5kxQAiQuD3IXiI+XfP CHUSJ8PCEKqoLRE51Esklhk/uC/1wOm/jByBA0JU4po0jmPpm0Izz34Hqk1QJ3DK/dGXbMmv3Ea2 9TLpaLOPU5x/voiWDlbgNfU6ol90h8e1f7/IduNLw9bUJAiGv4tjvYWzkGL8zZYcjqhHUlRioTyz E22AOoWzlFA1dRmzUl3Nvl5G9LBTkawO6/e9T7mvriC8uiPQAP5y/STz3F5JsHlal3WDMUXyEURk FANMhzTvYC+f3ZnsPDST1KPwiTjw6Q1ihDqFsyID8uJyCmlrOZtLvUyMUTrpmMvyahokbeLYBPM5 BRUBCdRVeXZOZ/USFVHIKk6sLdYpnCqnC9XMpV7s6PZa4Rz5++8uJ6+mppo59n6CYUayXR3tfWwW VVzmuwYxoEUXvbsxV3qGYUOrTuS9lzrXToQBlqiF81Pnkg4jm5yRjbhxqReJhn3FTqsg5HPvCh7R XSqcQB+04/BaIw9whHoR0Ja3BxWfYGCXqOu+OacciXRmqLnp2yJRpZKmnD78pQs0qNmUqZCc6gWi JYkqjofSXq5Gcgt52HnBaYWUBxTHcTpdMCmRooV25IwVzjVrkey+mDRn6qV6qzdGONXTXy7QjvVS SQXB4yhtdY+dt6R++pNyUm+1hxa7ImzuBvHOB4jUdRBWHSffkOd0SCUa3bVeMvxbYrr7Jn93e4JO 0bxoW+dFbjid099YINVL+rf+8uTDa2Auh13UchTmlb+LYLSbB8JBzqN7Z8FF+FhiYMCDRniQ9AsM /ACHeYPeUuWHLAAAAABJRU5ErkJggk== , which is always satisfied since Project III by assumption has a negative net present value, i.e., data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAI4AAAAQCAIAAABP89BsAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAzlJREFUWEftVzty8jAQlnMWk8LDCZwTJDRUtHR2CU26lOlooAwdbSqa3z5B fALGBfZd/O/qZT2MJZvATGZQJcxqd799fCsFTdOQx/oLEXj6C04+fMQI9KUqT4MgzUHI3mjBq3cv wcuuvnlApRu3sOQF9l5IGUATLxAgX1nCQxBvK/opS/jO3shD1TYmQh5PUBVJ1mpFAaKItP84d1xb q576NE6XhzEH2E6k7AzDqON2GmQCrogpeImSJxZhtEt3sJFfjI3wA0S0QMKZJEmUb1ckirui62cf rW+ecekRc4HtQKrWqAzaYE+cEZOWGQHWu899kn29iraKJrCryumcfrE3XK7+900Ws1Dho6okUdT+ zjflAiKrywyiL/tsOFuQ9QZ5WbGTXsvADrBdSAvFt6osEhasocsZMYmXpaq1lKeT9fRjFdLsnc4w gOyN8Ab8L6bPaqbqM4lmz9OirFAmTz+jOTFl/LHY+ulZ8D2mnrXr9as5kGWAyzU0cQAIOdjTWewE 24X0RFrs+XEf0/IevDwiJvFywgROoWSljhlXM1tdz1iEdyx0NhD5NbMFzna608s2vXMDJ4MYL8jU vmi7kOpZGcnJXhHj1rGr6vMJezlc/TQZeXOVZU/hSBaBPt0ty/kqxHIz6E+UNStuuWyz40oVUeCa H+0OQ43bA1AGrtOefEjKH9oNQENKcqACdHahlGIAbJtZMeYVMS6PqQK7wtIkijl7DXUevTuekAVC YMD1W4lxgCKwQABZda0fHkFplxcQ/Q2XZMZUYvXQDV6oYR3nTWPoVOoGZ8/2fdRwQRf0CoRf9qDy gukXMTCIeCFVSvXmm3XhT7rG0AA9LOOQ75jGASneX51RHEoBgVv8hkPzZo1IelKU8ZIcsBT6GiZP l9+sAnb69eRSfRpI9Qoc1/084x4Rk3jpaAHa5l76sjdrDIXD7QfCFa8N+VKRXcSfehcu62jcw3Px cgRRuh0wYGyk3GDX48815C89qTojJi/rpH3o+hkwpMY/KEaZu9GryseXeyOVzSAKisi3n4+73TLt vWq8Dp+T97Jz2Zf7emBYC4D+yMGa6SMuFY8jN45AACV0YxMP9b8Tgf9AkB3ZnjietAAAAABJRU5E rkJggk== .

232 See supra note 211.

233 Dewatripont et al., supra note 185, at 49; see also Macey & Holdcroft, supra note 2, at 1411–12 (observing that for capital regulation to solve banks’ moral hazard problems, it should be so extreme that banks “would cease to play any role in providing capital to the economy”).

234 See Rafael Repullo & Javier Suarez, The Procyclical Effects of Basel II, VOX (July 14, 2008), http://www.voxeu.org/index.php?q=node/1398 (observing that “Basel II makes capital requirements an increasing function of banks’ estimates of their loans’ probability of default and loss given default”).

235 See Skander J. Van den Heuvel, The Welfare Cost of Bank Capital Requirements, 55 J. Monetary Econ. 298 (2008) (providing a formal discussion of the effects of high capital requirements on banks’ access to deposits); Anjan V. Thakor, Capital Requirements, Monetary Policy, and Aggregate Bank Lending: Theory and Empirical Evidence, 51 J. Fin. 279, 281 (1996) (showing that high capital requirements may increase credit rationing and negatively impact economic growth).

236 See Laeven & Levine, supra note 45, at 260 (“Owners might compensate for the loss of utility from more stringent capital requirements by selecting a riskier investment portfolio.”).

237 See Fin. Stability Bd., Addressing Financial System Procyclicality: A Possible Framework 7 (2008), available at http://www.financialstabilityboard.org/publications/r_0904e.pdf (advancing policy proposals to mitigate the problem of procyclicality of capital regulations); Repullo & Suarez, supra note 238 (arguing that Basel II has exacerbated the procyclical effects of banks’ capital requirements).

238 See supra Part I.A.1 (discussing asset substitution).

239 See supra Part I.B (providing an example of the potential systemic risk that arises from asset substitution, given high interbank correlation).

240As made clear by the ensuing discussion, regulators produce externalities to shareholders by imposing higher capital requirements, and shareholders impose externalities on regulators by selecting Project II. In this context, the contracting part of the Coase Theorem states that parties will find it efficient to contract around externalities in order to reach a Pareto improvement. See R.H. Coase, The Problem of Social Cost, 3 J.L. & Econ. 1 (1960).

241Formally, Project I has an LGD equal to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAE4AAAAQCAIAAAA3TN7NAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAfJJREFUSEvdVjtywjAQlX0Wk4LhBOIEjJtUPoJdmgOkTEcDpenSpkoTfAJ8 AoYC+y6OJEuWVkJIyCGTwR1i9Xbf25+ivt0uNyhDKK3KBD3zF6OkPFbpM1MU3GIHyW63jJa77oFS 1EUUFfXjHEj8nlQwZo7wtu3BR/+Qh4dcDccwhldv/OI4AICchQM6PB9yDo2shoQodE+Z5wdmz9QJ DQ4qyP0b3rylg4ZENB6jBOYH1gLuvj9RlmqDCs9nLLVJ+bHFzbkNLTtsICdphtabyXVcf+3z15Ua Vnte8AMbVcK0WbyoTM2T0yWkh02cQb00wyYgbbQrnzI9uMXQ7YIpORxMut37XqC6xpIUqD03mmBQ Ct8MmzjjTbNOVtXVQj7KvUgtxBjpLidRdxyTrJdeGMeaZtaAiWAKDE2NhorcGeDC6xd9RbLZiVzK npvNsZmHWFPNBkcFkw1Wb9ZN/qY9OdwZoBWl4JBFBreMqYGPfGMuSb0MBAln0aAqH9uk00aiMtlY ucAx5z8uIY6Cosx3fzRmSeOhQBz66oCndjeXDdgtUp9QmuMGF1DKupq0bODKt4Vnpzpsz2Bad6Vm ElHuydioegS3qIrqCH0r+LGlKfkFD2610Dip/yiBfvzvt3ImtY9ov7IlUBSoqsBDY+oS+Gf3fwBc t3rcS99kggAAAABJRU5ErkJggk== . Instead, when Bank Alpha switches to Project II the LGD increases to data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAJkAAAAQCAIAAACKgUr9AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA3pJREFUWEfdWTt26jAQFW8tJkUOK3BWADRUtOlMCQtImY6GlLijTUXz7BWE FeRQBPbizOhn/WyPjEmBKkWM5mr+M86oqioG6/rx8soOX+tE7Ldsydh8z/+88zKR7wz14Oz/CfnK 7YYt59JyyfprP/8zuZP122SzLf8M73GBhC3LY5693TkIy9VotEKT6Y3S6nSR5cegMSFmRy8f1zuq 33vM8FjNgg+GJSEgx1ZFxtLdBXdiXXYph7EO659JO+AplmJSZHKnNxZeVjhs8RH1AzS7Gx8m+ViS ueKT5KMTtQhOZ9JOKSCYNJ2nyq7LrO0Gakz8jhbhO9jok5DdHL8BcvtEM5Ku1tfPbBepnbcvP1dP ILotXqvgvYzZBIE59nI+pc/jwQIeeqf3PCv2UxWYnPflPFnwE72xAU/ni3Fw/f9Z1291rh6ZrA+7 1KaPenyqOwN1LZkv2TA1G6uVkFOtdsEhO8YWkUYIsOX155tNngbsWME3pDzlaryZYCFG837/QOHT G0v7ydOE8Z/lAlOe7Cf5JyY93ZQ+H34XjJn6DLEMBZatfEnEWwHeeKAptYk6BGfTfXVgrxyk2aZE CNnH0pXRTQnyQARh2zI6LqqKxye0xhUfePSmm49FUfuHOu7nfj4fDeNHOig6tMTkphYSqWoOYeFk OILgSIJL2VR4hbmIEAFbOp5oMK39dJazfKYIbYdCeSCJ4QsLNotNIA0mFv5hhq1bFUgxhHEzaDkR L1LRWFeG8XMa7WvKpotjIEYpEAFbOq7ouKD41Sq/tp+C5ysxQKIbypoBLP1DnsAwfPJGKFIMmXwg cdgR4BuZ5h9YpMRdLToYVXYHMemHpzKRzGyV8jpIgBBtYWwX57VS2gGMBh8zD5FxYCoybxpwPJ1F dt3m49RVWwKjS45vLVXXLllG61Nl6BZdkSBwJukxXzXaEmeJLBPjKV3nvirdEaT277521FOzYmWo zpuAIg1qT78xL6yntw5IAsTQ86X/IYCilpA33RQqFFDzUwUxfbSybc5VUa9pI26HwHqJDXnDR7Sm dA/VSc+PJg3k9eiaL6qBP/NB8xRsA2JKUCctlkT9T4VO6jYCv4e9iV3ocgcE732c6UqXfL877nge NnLxXx2CHwY4EjY0bhswrIaGQzB6vmGfWHPrgpAhHYjeIotJ/P3zyK3Fqj/yg938BYpeV6I0VSM4 AAAAAElFTkSuQmCC , where data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAHYAAAAQCAIAAABMaBwBAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAo5JREFUWEftVztywjAQlXMWSMHkBOYEJA0VbTpTQpMuZToaKENHm4om5gTh BBmK4Ls4u/p5JdmWpRhmMsM2GFn79u1qP3JSliW7ySUjcHdJ8Bs2RsAf4sM8SeYH2KofeozcRTFr wIvNOBlvih49sKFco/4QM5auXyYcST/0SPHPmOgTlyp09YQxvM9sV34tBjJhpKKhG+qaNK+NT97L cro3zhF6MZU8Y1lOF87rVCzoB0sj4G8zeACITVfyBXriqYEwLKfrM1HWClwF84e+7U4IlR1das3K 4sN+m01Fyko5nx7Egn4IPWe9vwU8DrPYvG2z/F3xTUdDytMgXHx+sNkTpi8RocDYYLFbp8fTOY4F nI6DPHiaseUK2ysIZBaKyFSVZvArDkYfUe1ZeY+6I7hTSHW+1mRZVRVoSOWwoG4SJikrjZkrce7J 4rbqXhio8pjRyOplHWJvEP0bVBz6BxcseZWbzc0l5YbYbFrue79jYofT/JwjxEahCrgqpuEofbi3 qsrNLD1oqrFhjh1UiQX3F23x840VOlh8lTl7DLwnAC3VJsASeH4kf7ntTt6he7aizRxCjFRlFzuK wIJF2YBbHcXhWSNiYkuJAO/mGw4HSZcxSImwViqPR5I8rJbH7JXShhddvOOxU40Ybiz8cqtFxZ6n Oi80mfLxbaku3pcDJ80MjXguBNaFgpQ3nxe+RtPUNkwcgkI6j+rFJPix5hpoyJEnDfQGjjHLMmjD ZFq39U/7jlY5HE2JTwGatdW1j54oD3Fr3+7a91v3NQ2FePA8C73Ixo+0UJZmyeh7sW6a/jkTvqN/ cEDsMJANpjgX4bvrCh/Q8A1JB9L/TGLnWy000a64PwFb4Vl50wiIwC82NE0FWsvoPQAAAABJRU5E rkJggk== .

242The level of acceptable LGD can be interpreted as a function of, for example, the targeted value of the FDIC Deposit Insurance Fund (DIF) for the current year, the level of national deficit, and the shadow costs of bureaucracy. The latter are the transaction costs that the government bears to channel public funds to troubled banks. See Jean Tirole, Overcoming Adverse Selection: How Public Intervention Can Restore Market Functioning, 102 Am. Econ. Rev. 29, 55 (2012) (suggesting that the magnitude of government intervention must be balanced against the cost of public funds, since the use of these funds is not a mere transfer of resources but implies high transaction costs).

243Letting data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAA0AAAAQCAIAAABCwWJuAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAMZJREFUKFNj/P//PwMRgIkINSAljATN257O6MWwjRjzrCaUeqKrA+pO347s lju3ruioqTAwAO1FAtvSGNK2oYmABRiAMiAAkYUpA9JWE24DBW5PsIKwmDxngqXBAGiHlZYqsq0q +Uf/H80HWgty3/YNs9ICPIHKtq5iCPMGCjKoalmBHYUAQHVwU25fOwaRBWrQAWlEBhBbQc6DOg7u JBTvgP0Lcx9EP5qHIcoR4YIZJMgGwsMZ068ozoOrg3sCe8IgnA4g+gAWBcVJsFygEQAAAABJRU5E rkJggk== be the socially optimal LGD, the required increase in Bank Alpha’s equity capital is determined by the following equation: data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAKAAAAAQCAIAAAAeZ+MPAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA+RJREFUWEftWLt24jAQFfstJkUOX+B8AdCkok1nSmjSpUxHAyV0aanSrP0F 4QtyKGL+xTuj5+hhyw/Inj1ZVUJIc0dz5yWPqqpiMC67hyf29rFKxHzDFozN9/znjQdFvjHUTxT/ S1y62KzZYi7pTFYf+/m3GSNZvUzWm+Lb8H4YkCC4eD9kLzcO12I5Gi2RRz1Rpp4+Zod3m2EI6xEf /IQauPqwu/w1ijzNB2mC0nDc5EZGVUjRVZ6xdFviTIxym3LVrUXzd6sZyBRDCckzOdMTCy/LqVjQ wAFHncySlj5YT3NjCmjLp6ZwbdXKGHyTlGnfq7+4ZmBtZIzgy9cnm9yRcgs5mh8XJTk0wEGs2HL2 wN8zxhkrt0zkXwARGHpiziTzRfr51RSZl93TcVEafabPwLf0CYQYDwsDqFAn6wpUPl4i0/Vrui8X x6c+aYTLTLdvN8iUHh3GyEhweT6l9+NB6cY6fNm9HrJ8P1UhzGWX58kjX9ETG/B0Lus1uPw+mhZB bVM6J6u3bdp4PHK1Yvl6X+aZK8LYJFnRdhPcUTptd5Ol2lG6n60/gRVWGFcNY2Qg2AvgodjgMBKv WI7XEyzuyDmPUT2xQJK7CWsIYeD3ZKUY5q80Z4CGK4FGzOs/jPxi6aWqeMIJwvk612mlqrOo0XqQ LCV3CNUUv7AotlAjyy56KKf0POCB8/M26f2xqngkY9LnCVZPhiEaH1JybAdoLR1y//lFJhviIyCf HWZo2tlnMLn1yBi+znVaTvfBAksqJu5QfQIEqJOAqZEDBDt+Q7QwnjU7yPv7bSDiQSJCkJzNhtXG WhfnPqT+xdBwa0w8CPjpYnNcPPPkNr4XjaVYBvmi68yzuOe0wxJ+39rzohtV3JryBVfwlQ0Q7HgP QTKeBd5j2l67FwNHVTCA2MPTo1fDokKKGXZI3iMvHgTI43JGs7PWlRSt6V73EpZelKtWWFRnyG5N LSp/SAaGFSw6brW9gWnZ5lBNJcG9K5jHBnFUtPxVnNYtesSHsF+nHV3cO/QOLL6mFaRtAE2mATLa F1OiDdV5sw4wEQwkK9isQAJ53CFlIIOaY5WMbBsEnsEtnnZWBLsP2CxT2c5+3NbLxUeutdd9B5MN 6pEur9EWwgV3xHBpPC17f7hfA/w3etRgrkzrQd/3a4P9Vq+zA5PfNTraqZZg/ytG9PYhFwt/6Oio ZBvkznt60NuEMfRDRy0RChQJ5k57HeOBpB6CwnTyoLKkoc/29ffOTAYOXBdfReCQG8XdjROMDBMY HfuduYrjhezc79Q1GPvnZUQDuBIE80eVS2eedSa4l8H+89vLbC0P/QHSKjaqyMVtRAAAAABJRU5E rkJggk== , which gives data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAJkAAAAQCAIAAACKgUr9AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA7NJREFUWEftWDt64jAQVnIWkyIfJyAnABoq2nSmhGY7ynQ0UEKXNlWa2CcI J+CjCNyFndFjNJItI5nHfvvtqpJtzeufl8YPp9NJ/F8XInBcvbyK9+9pBnxgvxBjIYZr+XjjxSU/ 3ljWP8G+XMzEeKg9l02/18O7mZ1N593ZopTy7uFLiJ0HuSZKZmCVE32CNvYgsnhZHW8IkScUH3HF CC0/N/n8lknYhIzoj/LNpwIWaqxdh2VP9JYHelHkHnr8o0PZ9ABca+iIt/lW5HpHG8XUVcpVqZU+ kqvm4zCAd43P2kjPHp8K9cXVWrdoZCw+eYG9kjtBMnFUQL3kOQVqzvwc7Up0hm8XSlJ8SQJs6A2J lN9dYqaSRK0tZH7cmrhh/HwvKZPhLdPPGhAJiEfuU8UjQ5QGIlZjy8nb86HIt/uDk4y9545+zqZX aufH1dsmL9Z9zVdJOOy7I/mGNvhw/PqwrcjoZVTKpu/Lnq9vQh3uUZMzRNlwLEz7CbUCqKhKUbUO +62FKEF47dEEZBx6CQL5EriIStEHJLfdJ2zq5aTa7ExPUZ2F1vkWA+ZrOMpJZ9ZFsWjE7gcaIm2k rlYBo3r1jSRLXlU+kgU4s9fIEJsjd+XxZycURNdY8cgwadlTV6DO2pfH1et+rhOFmQKsxWaAXhrs KD2JS39dW1bU1bxhARwQyfJG9Dk6naRYuP2dJCFtAgysteZAOySrfEhgQ6ZDpO2Wv1hWXsOBlsdF yGhflouPsdKw86wat1zIWnXIIm+HWJ2pEMlY3NBphRicz2KHh7LWvMLk8gtcXLVw+cR6pLbiu8Re kSIo9b0YsmKj06N6Tb4IGVVjy8mAl1cKS1Y++mvqbszVpF9SjYWMMIEBkZPW7rS1JtYWs21lGoiq FpwPFAi3fwTbX4Qr3bnA/oexWjl3H7eGXYIMQPKIDUrYe4ipvYgWL0MVg+F7FGqVkGcZATP2mXuD 376YtZB/A36Dis0teY7zWcz0pQs/BNqoJAq6sl3HvgyZOnP1MMQ/ybpqpiT60Pbu740VeIHOc1PI +eW+/k7vjyBW0fO0gSnBN41Z5k5A7kwSGCbqB5fwgBKcSVKR4TOJnJL8mhA5JCUdcwDyfgREMHJm 3Ijz7Y/4s6zjppAPUtUL+jIdGW2pUfNOvlTZBMFDfwTSEMcJun1hiJHlSTD/XkhoeMRPdWa4WrSr NBSB9/AlU77+d14M1n/2TKPelcJMkZugdGtkLOGdfZlg3N90tCZpi7xdlqWazWLgN+4c3Yn7uOFM AAAAAElFTkSuQmCC .

244Here the expected equity returns of Bank Alpha’s shareholders are measured through ROE to make the dilution effects that higher capital requirements produce on equity clearer.

245This is a simple normalization of the regulators’ payoff, which does not change the regulators’ preferences over the available courses of action.

246In game theory, a dominant strategy is a strategy that each player plays independently from what the other is doing. See generally John F. Nash, Jr., Equilibrium Points in N-Person Games, 36 Proc. Nat’l Acad. Sci. U.S. Am. 48, 48–49 (1950).

247Indeed, even with the higher capital requirement, Project II is still more profitable for the shareholders. Formally, by switching to Project II, the shareholders gain data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAALAAAAAQCAIAAAA5yWLnAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAA+1JREFUaEPtWD124jAQlvcsDoUfJzAnWNJQ0aazS2i2S0lHA2XoaFOlWXyC 5AQ8F7Hvws7o/w9LMtm8t29Rg42lme8bzZ+UXS4Xch93CwgL/Lib4m4B3QIBh2jqLKsbWCAf1OJ+ P8tm+/6b7OkB8BWavQSRGR2U+l8Y32s6LwHLnviKY0agZAyMU1XuOvwuH9jkblcS/oV+pDrZH/gJ R3UaFu35yuXoK5k0CUJTmiyd0eDWEeC9BEGpIqctuwosBYvXdBaqFHnOXFOBxlk4huQG1jB44vuw Q4BsZgT5INzBNJiJAd9GuANVU1WVthmGO3AcpuYU06E3SDrsyU/QcYgwsFgcjmjNWJTteHocAvV5 Q4qxH2BiFuKenUSHGC4ZXTtd/ETHkg/40v9+JcvHXMtEXftRqn/grWLLUkfXkqJQi5ptu4Rg1XTl j0uy3o5K5P1+c6hOLwJXWTzovAyCLuwgsEimrulw9ygUQvLVcVd+tF2krCuVYFN0p8qWIlSgkpeV 2jrXntwhZAmBngCeWe1EE54/oUmQDxQDkPqYTnR/6D/PRP3TvB2U/iRy/ScpHidTzqapN8WCWLqA QUkxJQ/lpk39sJ4+g1muEHRFRwCLwuMxnWPMceyYeiBEkJgxlNKmdpoix57oEOAB8zOr/8t2W28I j6N89X55R/Hywc8aNZLDnHUlWTY/6DEdZShOBzLPJH8o6I73+7fiuCKQenj8KEGjgoi5KW0X3xaX C80UCQSjgCVwFVPdbGrGWorIfv/UPvMUqLkVqOC7Mz87tkT5hj3BIdBUuyP3q/OBCJnRWLBgqLoE hcjhJBKQ8Bn+a51RtLTdAbfFKkdoZnHygIoSDkkMJaELnMg88XAUBSwKhg3fzKYYWbb/x4tttq/L X7QiQkwpRXR7+cEgxtmw8Rbb6TZTvl7J7hnNXhXexjWU8iBDuyLR8jnC4jA6uDVY4Z7X0iFOIsPA YtpKW7WpSDW9MbKsObrddTUhtjoEq6ls6qdXVoj2g12bVXa+qoEAT2YODP5d7tDVfQHjVuGoRKZF YrNde8rQgJQ4YFEw7IoNuVUELdZtvemNkicnYfOgGuZ8MiWiZug1CQqm3US49lTnVAhK98ji9VXN 68TBnmUF40Iiyc3dKwjvfcbI/IDL4DzL7RfMYFbU4DJtzQ0XLeyWhssScmJRXbenJYkKpFnf+WAf ap0UFbiHuIohlIiSnCF68kh3cK7VQgpH6wkJ5lcpY4tqjPiUOTbP8MXUoHQM6puvUaLx36JNXj9F apOBFcwlkQLtabeQGakyAEFk+jKDiWnl6t+bDaXziRzpAfo+Qhb4HxwiZIP7d80CfwCpMChY8GOg VwAAAABJRU5ErkJggk== , which is positive since data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAJkAAAAQCAIAAACKgUr9AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAAudJREFUWEfdWD124jAQFnsW2ILHCZwTsNtQpd3OlGyTLiUHMCXp0qaiwT5B OEEeRey7OBr9jiTHHstmn1kVPD80+mb0zYxmJFbfyWBogMl5mubS9DJL1GeeJlkp/9TTeYrWyVkh z3+YEW6ioAnfQZ4ebz8wR1P+xtSBnYsl+6yEweV1tVnDR3H6ePw9F/9Vn2y5gI/1UXg2E15838Fs eeVz8917vno7S4SmEeIXhwMXN8gTJGt64UW1SGYOJJgaOlFx0qoslb7UaQwJabP5O30+vkhjm65U M/+dHFPnBo6y1rOHZJp/gjknHaiKUKGdhpZy2BAI5KxXA3PBh1nXAatWefgdyCRmeDCMRrWCMhRI X4roVgQIziK4RlsRShwIh4YyS22a0BiwUqgm9l2qwnbY3qKU4kUjUu2ljK2XiSwwbL57zZLLtYyu B8V2vyzz1IfQ+KDhKApX31EdHmaz00ZWvdixPg5bH6vXycY2qovt7AEKM20kukPg4tKX1fntsvqJ KfpQjQUNEUlVhz179tm2+MV2W/iY3PqmEeyI9yt1vTnNQoTeVo69gLoFAtW8W3tlfwQhHT4NvKbr JSoxA+qC6SjcUoOKRPQJZzBaiuHgA/D2AHwbZKp1i/DNjl2ouhb10iW+6eoVNC8ysH3H2GLGQeyk xY9vA8fOpKF4kV7vproBGNgPcyDo/MCXDu+i0YoLfRwnOLe78pwYKHT2uu8bdCyaJHULPalWidno DgwlNwy+RD4QNsV50iMQRY3n4zh4GqfmvnlbJVRjAjki1To02gqSCwX7ZeiuDcdOLAcejD2Bg4no gkknsF9emvgdEMgk22hUk85Fn1VBqrpfkmy5G6F+vjTS/ZZNj427eY8l9yr8Frr4e3n51X51EZcI 2fOL91mANx9kXRMTnF543cAi9baukXUCiq7a1B2/xR/djhbPj6Lr/8vL7lypztfHpzWD96mnxWH/ wuBhhL9xyI/bjRaHjaL0C33MjllnmMTOAAAAAElFTkSuQmCC .

248This is trivially given by the fact that data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAAC4AAAAQCAIAAADmq9q9AAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAASpJREFUSEvNlMsRgjAQhom1qAeHCqACblQBFdgHHLUET1yEDqzA4SDpJW6e Ex4JCwMz7IWQx7/fbn4gjLHgGHE6BganmEdpckLyZg9ioywH8yhBEBX3ZA8US5mnGKIAYL8F9PcN r+cNSNzKKsUApameWdprQdeG/QkHFS1jEpfUyexR1inqTJzOaviUGLyIATyjooNBV0RqxJcnQwnI /XYglU2KwCaAWaloUJwAYo9VhJtT1IZR5ii6F2Y/Pynb5OmEd4M6t0gZvAKuiW4XqLBrP9Kh9P3y GyR5MJZWhIfvO1+oLDvNS1QlIOwx4QhltrFb8MraK5bzMZ0fXxwvyGldpe5XFigi9L16LLJyCals /ivmXjf4m/UlsMoGxXh2cxSsMoGmb558neAfUG/yMxH5UbIAAAAASUVORK5CYIJ= .

249It is important to emphasize that while the strategy profile Project II; Status – quo Capital also yields an aggregate payoff of data:image/png;base64,iVBORw0KGgoAAAANSUhEUgAAABcAAAAQCAIAAAByTXNPAAAAAXNSR0IArs4c6QAAAAlwSFlzAAAS dAAAEnQB3mYfeAAAASFJREFUOE/NkzGSgzAMRWXOglMwnMA5wSbNVrTp7BIOkDJdGralS0uVJvgE 4QTMFjF3YWXLeMxMNptJmlXlsfQ/1pNg0zTB25G87WANgotWSr/uiB1NnQx6URt748MmZBddhKOp xaxBCb5Fqw106ITlpob2Mtr0+LVmjB2GULt4p1a8yskdJRVPYLwNIuNUlJbXa5n6E5acirtNogTk 5wdJtoVALmm5zyvONs3zVNJVDs2ZMI6XtpfgO6U+l1Tsc8UvXFzKheU2zwjtZWeKlj81Ka3YDk7E JTuw9WJfbI/DzdF9GPrciGLr+DkufYIjYuH75rvPV5S9E1hJpTwTfXX064UaQC7R6CMI8a1fmnh7 lis206V9eTXYf/wb/5rLw/wPBjcZKnzAUMYAAAAASUVORK5CYIJ= , the strategy Project I; Status – quo Capital is more efficient under the assumption that the shadow cost of public funds is non-zero (i.e., not negligible). See supra note 246. Under this assumption, since the regulators’ expected bailout costs are higher for Project II, the outcome Project II; Status – quo Capital is strictly dominated by the outcome Project I; Status – quo Capital.

250CAMELS stands for Capital adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity to market risk. The CAMELS rating system provides for both the assessment of individual component ratings and a composite rating. Each of these assessments yields a score that can range between 1 (indicating the least degree of supervisory concern) and 5 (indicating the maximum degree of supervisory concern). See Fed. Deposit Ins. Corp., Risk Management Manual of Examination Policies § 1.1 (2012) [hereinafter FDIC Evaluation Policies], available at http://www.fdic.gov/regulations/safety/manual/section1-1.pdf. A similar system—the RFI/C/(D) ratings (Risk-management, Financial condition, Impact, Capital, and Depositary Institutions)—is used for bank holding companies. See Div. of Banking Supervision & Regulation, Bd. of Governors of the Fed. Reserve Sys., Bank Holding Company Supervision Manual (2005), available at http://www.federalreserve.gov/boarddocs/supmanual/bhc/bhc.pdf.

251For example, the evaluation of a bank’s risk management system is based on very detailed provisions in the examination ratings. But even detailed risk management regulation is virtually useless when the overall organizational structure is subordinated to a CEO with a large appetite for risk. Unfortunately, existing examination rules fail to adequately tackle fundamental issues of control, such as board composition, expertise, or independence; instead, these rules are vague and only employ loose definitions, referring to indefinite attributes, such as “ability,” “adequacy,” “accuracy,” “[r]esponsiveness,” “[r]easonableness,” and “willingness.” See FDIC Evaluation Policies, supra note 254, § 4.1.

252The FDIC’s “risk-based assessment system” classifies banks into three capital groups and three supervisory groups, which incorporate the CAMELS ratings. See 12 U.S.C. § 1817(b)(1)(A), (C) (2006); 12 C.F.R. §§ 327.9–.10 (2012). An excellent description of the FDIC risk-based assessment system can be found in Risk-Based Assessment System, Fed. Deposit Ins. Corp., http://www.fdic.gov/deposit/insurance/risk/2007_01/fr_risk.html (last updated July 7, 2007).

253It is worth observing that in the case of capital requirements, a theoretical exchange between safe governance arrangements and lower capital ratios is provided in the prompt corrective action system introduced by the 1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA). Federal Deposit Insurance Corporation Improvement Act of 1991, Pub. L. No. 102-242, 105 Stat. 2236. This system classifies banking institutions in five capital-based categories, ranging from well-capitalized to critically undercapitalized. As a bank’s capital rating declines, prompt corrective action rules impose progressively stricter regulatory requirements. These rules also provide that a bank can be treated as if it belonged to the next lower capital category if it has received an unsatisfactory rating under the CAMELS system and has taken no corrective action. See 12 C.F.R. § 325.103 (2012). In practice, however, the largely residual scope of application of this rule, combined with the bureaucratic nature of the CAMELS governance provisions, makes it highly unlikely that this principle can have real teeth. In fact, when one considers the broader context of the prompt corrective action system, it becomes apparent that within this system bank governance only matters when a bank’s capital level falls to extremely low levels.

254Under the same logic, banks adopting safe governance arrangements could be subject to less stringent activity restrictions. Since these restrictions impose opportunity costs on banks, they are a subset of regulatory costs. See John et al., supra note 9, at 96 (jointly considering activity restrictions and capital requirements as suboptimal and costly means to discipline banks).

255 See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 115–16, 124 Stat. 1376, 1403–06 (2010) (codified in 12 U.S.C. §§ 5325, 5326 (2006 & Supp. IV 2010)).

256 See supra note 24 and accompanying text.

257An example is offering a menu of contracts where each contract specifies a given price and quality label. The underlying intuition is that adding another contractual dimension to the negotiation between principal and agent (i.e., the quality label besides price) enables the principal to infer more information about the agent’s type. Economically, the adoption of this strategy implies a model of screening, rather than signaling. The seminal contribution in this field is Michael Rothschild & Joseph Stiglitz, Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information, 90 Q.J. Econ. 629, 643 (1976), which studied screening in the insurance market. A model of screening—where the principal rather than the agent takes action—better characterizes the nature of the regulators’ intervention. Nevertheless, screening is equivalent to signaling: both strategies aim at achieving a separating equilibrium.

258 See id. at 629, 639–40.

259This Article opts for a two-governance system instead of a large number of regulatory contracts because benefits from having multiple contracts are uncertain. At first glance, an increase in available regulatory contracts could seem to add to the precision of the system by synthetically replicating an assessment method based on individual negotiations with banks. But, in fact, this system can never ensure that the self-interest choice of bank shareholders for a given combination of governance features and regulatory costs is socially optimal—as it happens, instead, under an ideal system of one-on-one negotiations with banks. At the margin, enlarging the set of available contracts may increase, rather than decrease, the risk of mispricing. And even assuming that providing for more regulatory contracts could add some precision to the system, designing such a system would bring about enormous implementation costs and, therefore, raise feasibility issues.

260 See supra notes 22, 229.

261 See supra Part II.C.2.

262Some empirical studies show a positive correlation between the financial expertise of board members and volatility. See Bernardette A. Minton et al., Board Composition, Risk Taking and Value: Evidence from Financial Firms 2–3 (Aug. 16, 2009) (unpublished manuscript), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1455997. But this evidence does not show causation. In a CEO-centric governance model, the expert decides on the basis of the restricted, and biased, evidence provided by the CEO. Instead, in an advocacy model, experts are likely to add to the information aggregation process because they would be better able to assess the conflicting risk information produced by the CEO and the CRO.

263These requirements are largely in accordance with the Basel Committee’s recommendations on improving bank governance. See Basel Principles for Governance, supra note 20, at 18–19 (Principles 6.72, 6.74, 6.78, and 6.79).

264 See Rajan, supra note 1, at 140 (observing that “risk management was used primarily for regulatory compliance rather than as an instrument of management control”).

265 See FCIC Final Report, supra note 93, at 18–19 (reporting that repressing non-complacent risk managers was a regular practice at major banks, including Lehman Brothers, Citigroup, and Bear Stearns).

266 See supra notes 23, 229.

267The current corporate governance structure of Bank of America, where the CRO is compensated through large stock option plans and reports to the CEO, offers a stylized example of a bank that would be deemed to have chosen a CEO-centric model pursuant to the regulatory reform envisioned by this Article. See Jeff Green, Chief Risk Officer Rises to $10 Million Job Following Derivatives Meltdown, Bloomberg (July 11, 2011, 2:18 PM), http://www.bloomberg.com/news/2011-07-11/risk-officer-rises-to-10-million-job-after-derivatives-meltdown.html (reporting similar organizational features at major U.S. banks, including Bank of America). Therefore, under this Article’s proposal, Bank of America would be held to the higher set of regulatory costs.

268 See Top 50 Holding Companies, Nat’l Info. Center, http://www.ffiec.gov/nicpubweb/nicweb/top50form.aspx (last visited Oct. 14, 2012).

269It is worth observing that the proposed adoption of a different regulatory regime for small and medium-sized banks, on the one hand, and systemic banks, on the other, would replicate the practice of private debt contracting. Banks routinely use standardized contracts when lending to small businesses or households. In contrast, lending to corporate clients involves detailed, lengthy, and sophisticated negotiations.

270 See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 115(c), 124 Stat. 1376, 1404–05 (2010) (codified at 12 U.S.C. § 5325 (2006 & Supp. IV 2010)).

271Bank regulators have already performed similar tests. After the crisis, the Federal Reserve, the Office of the Comptroller of the Currency, and the FDIC jointly launched the Supervisory Capital Assessment Program. The program was tailored to estimate the losses and liquidity needs of nineteen U.S. bank holding companies with assets exceeding $100 billion. The test found that ten out of the nineteen banks under examination would have required an additional capital buffer to remain solvent. See Bd. of Governors of the Fed. Reserve Sys., The Supervisory Capital Assessment Program: Overview of Results 19–37 (2009), available at http://www.federalreserve.gov/bankinforeg/bcreg20090507a1.pdf. For some banks the required additional buffer was significant. For example, as regards the level of Tier 1 capital (i.e., common stock and disclosed reserves), Bank of America would have required a 19.6% increase. See id. at 21. The 19.6% increase is obtained by dividing the SCAP buffer of Bank of America, i.e., 33.9%, by the bank’s Tier 1 capital as of December 31, 2008, i.e., $173.2 billion.

272To this end, regulators should also privilege on-site examinations and resident examiners over off-site monitoring through certified reports. See FDIC Evaluation Policies, supra note 254, § 1.1.

273 See Dodd-Frank Wall Street Reform and Consumer Protection Act § 115(a)(2)(A).

274Recent empirical studies confirm that the relative power of risk managers vis-à-vis top executives, as measured through risk managers’ relative compensation, is among the most important determinants of banks’ risk management policies. This argument is supported by the fact that banks in which risk managers enjoyed more relative power invested less in risky assets before the crisis and performed better during the crisis. See Ellul & Yerramilli, supra note 203 (manuscript at 16) (finding that the presence of a risk manager with high relative power is negatively correlated with increased risk taking before the crisis and positively correlated with better performance during the crisis); Keys et al., supra note 82, at 702 (finding that relative power of risk managers has negative correlation with loan default rates).

275It is worth emphasizing that bank regulators have already taken similar initiatives under the Troubled Asset Relief Program (TARP). Notably, the TARP, which enabled the U.S. Department of Treasury to purchase toxic assets from troubled financial institutions, was a central part of the government’s effort to contain the systemic effect of the crisis. About TARP, U.S. Department Treasury, http://www.treasury.gov/initiatives/financial-stability/about-tarp/Pages/what-did-tarp-do.aspx (last updated July 13, 2012). In particular, under the Capital Purchase Program (CPP), which was the first and largest initiative conducted within the general framework of the TARP, the Treasury purchased about $205 billion in senior preferred stock (Preferred) from troubled U.S. banks. See Capital Purchase Program, U.S. Department Treasury, http://www.treasury.gov/initiatives/financial-stability/TARP-Programs/bank-investment-programs/cap/Pages/overview.aspx (last updated Dec. 10, 2012). In a little-noticed part, the Treasury’s term sheet provided that “[i]f dividends on the Preferred are not paid in full for six dividend periods, whether or not consecutive, the Preferred will have the right to elect 2 directors.” See U.S. Dep’t of Treasury, TARP Capital Purchase Program: Preferred Securities, available at http://www.treasury.gov/press-center/press-releases/Documents/term%20sheet%20%20private%20c%20corporations.pdf (last visited Dec. 23, 2012). Even less noticed was the fact that the Treasury did exercise its rights to elect board members under the CPP. In July 2011, the Treasury announced that it had, for the first time, elected directors to the boards of two recipients of CPP funds that had breached the six-missed-dividend waiver: First Banks, Inc. and Royal Bancshares of Pennsylvania, Inc. Press Release, U.S. Dep’t of the Treasury, Treasury Elects Directors to CCP Banks’ Boards of Directors (July 19, 2011), available at www.treasury.gov/press-center/press-releases/Pages/tg1249.aspx. By October 2012, the Treasury had elected twenty-four board members to a total of fourteen CPP institutions. U.S. Dep’t of the Treasury, Troubled Asset Relief Program (TARP): Monthly Report to Congress–October 2012, at 9 (2012), available at http://www.treasury.gov/initiatives/financial-stability/reports/Documents/October%202012%20Monthly%20Report.pdf.

276It is worth observing that shareholders, through the services offered by corporate governance rating agencies, already use corporate governance metrics to evaluate the soundness of potential investments. See Paul Rose, The Corporate Governance Industry, 32 J. Corp. L. 887, 917 (2007). While regulatory governance metrics should be tailored to measure stability rather than profitability, the experience of the corporate governance industry could serve as support to the regulatory identification of key governance features.

277Macey & Holdcroft, supra note 2, at 1409.

278 See Dodd-Frank Wall Street Reform and Consumer Protection Act §§ 115–16.

279 See, e.g., Rajan, supra note 1, at 147 (observing that the high volatility of the banks’ equity market was matched by high equity values).

280Since the rise of institutional investing in the 1980s, scholarly representations of shareholders as passive and uncoordinated have increasingly given way to a new shareholder rights movement. See Bernard S. Black, Shareholder Passivity Reexamined, 89 Mich. L. Rev. 520, 522 (1990) (rebutting what he calls the “passivity story” as obsolete and superficial in light of the growth of institutional investors). This movement has strongly defended the ability of shareholders to improve managerial performance and accountability through active voting. In fact, in recent years, the focus of this debate has shifted from the possibility of shareholder democracy to its efficiency. See, e.g., Lucian Arye Bebchuk, The Case for Increasing Shareholder Power, 118 Harv. L. Rev. 833 (2005).

281 See William W. Bratton, Hedge Funds and Governance Targets, 95 Geo. L.J. 1375, 1381 (2007) (explaining that hedge funds have been incredibly successful at using the proxy system to pursue governance issues); Marcel Kahan & Edward B. Rock, Hedge Funds in Corporate Governance and Corporate Control, 155 U. Pa. L. Rev. 1021, 1029 (2007) (“Hedge funds have increasingly tried to influence the business strategy and management of corporations.”); Ronald W. Masulis & Randall S. Thomas, Does Private Equity Create Wealth? The Effects of Private Equity and Derivatives on Corporate Governance, 76 U. Chi. L. Rev. 219 (2009) (suggesting that the great success of private equity funds is largely due to their superior ability at managing corporate governance issues).

282The combined provisions of the 1956 Bank Holding Company Act and Federal Reserve Regulation Y have historically required investors who gain “control” in banks (and bank holding companies) to register as a bank holding company, subjecting these investors to more stringent regulation and supervision. See Bank Holding Company Act of 1956, 12 U.S.C. § 1841 (2006); 12 C.F.R. § 225.1 (2012). In 2008, however, the Federal Reserve relaxed prior regulation. Investors can now seek to influence certain governance matters without being held to have acquired a controlling interest. See Bd. of Governors of the Fed. Reserve Sys., Policy Statement on Equity Investments in Banks and Bank Holding Companies 6–12 (2008), available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20080922b1.pdf.

283 See Masulis & Thomas, supra note 285, at 259 (“There may be great opportunities for private equity to become involved in improving the operations of [financial] institutions.”).

284Moreover, the costs that a bank bears to implement an advocacy model are likely to be private information.

285 See Sepe, supra note 36, at 211; see also Bhagat & Romano, supra note 52, at 370 (suggesting that feasibility issues might prevent firms from implementing executive compensation packages that adequately calibrate managers’ risk incentives).

286 See Dewatripont & Tirole, supra note 174, at 5 (arguing that advocacy systems are superior to systems where “a single agent is given a nonpartisan incentive scheme” to pursue simultaneously conflicting causes).

287When the manager’s compensation contract is sensitive to risk (such as the implicit volatility of bank assets), it is exposed to the countercyclical effects of exogenous factors. For example, during times of high volatility, the manager could be too conservative with respect to the optimal level of risk. Conversely, during times of low volatility, the manager could undertake too much risk.

288Government-owned banking is widespread worldwide: in the early 2000s about 40% of bank assets in emerging market banking systems were held in state-run banks. Rafael La Porta et al., Government Ownership of Banks, 57 J. Fin. 265, 275 (2002). For a critical assessment, see Levine, supra note 93, at 12, which observed that government might have “less benevolent motivations than enhancing the corporate governance of banks.” In the midst of the crisis, Nobel Economist Joseph Stiglitz provocatively suggested that both the U.S. and the U.K. governments would have benefitted from letting troubled banks fail and setting up a new banking system under temporary state control. See Judy Chen, Stiglitz Says U.S. Is Paying for Failure to Nationalize Banks, Bloomberg (Nov. 1, 2009, 1:10 PM), http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aGR4KXaGwxd8; Ambrose Evans-Pritchard, Let Banks Fail, Says Nobel Economist Joseph Stiglitz, Telegraph (Feb. 2, 2009, 12:44 AM), http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/4424418/Let-banks-fail-says-Nobel-economist-Joseph-Stiglitz.html.

289 Cf. Geoffrey P. Miller & Gerald Rosenfeld, Intellectual Hazard: How Conceptual Biases in Complex Organizations Contributed to the Crisis of 2008, 33 Harv. J.L. & Pub. Pol’y 807, 808 (2010) (arguing that intellectual hazard and conceptual biases may impair “the acquisition, analysis, communication, and implementation of information within an organization” and that these factors played a fundamental role in the 2008 crisis).