Bankruptcy Risk Induced by Career Concerns of Regulators

TL;DR

This paper models how regulators' career concerns influence firm leverage and bankruptcy risk through mechanism design, highlighting the impact of regulatory behavior on financial stability and firm valuation.

Contribution

It introduces a novel model linking regulator incentives to firm capital structure and bankruptcy risk, emphasizing the role of mechanism design in this dynamic.

Findings

Regulators' career concerns increase firm leverage.

Higher leverage correlates with increased bankruptcy risk.

Regulatory incentives affect firm value at risk (VaR) estimation.

Abstract

We introduce a model in which a regulator employs mechanism design to embed her human capital beta signal(s) in a firm's capital structure, in order to enhance the value of her post career change indexed executive stock option contract with the firm. We prove that the agency cost of this revolving door behavior increases the firm's financial leverage, bankruptcy risk, and affects estimation of firm value at risk (VaR).