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A Regulator's Exercise of Career Option To Quit and Join A Regulated Firm's Management with Applications to Financial Institutions

J. A. Cole and G. Cadogan

posted on 11 March 2012

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We introduce a model of managerial compensation, in context of labor market mobility, for regulators who design mechanism(s) that affect firm capital structure, and then cash in later by exercising a career option to join management or a consultancy. Examples of this "revolving door'' mobility include but is not limited to, politicians who become lobbyists; insurance commissioners who become insurance executives; IRS and government procurement contract officials who become consultants; corporate lawyers in SEC, CFTC, OCC, U.S. Dep't Justice who join law firms; and financial executives on federal reserve boards that administer bailouts under rubric of "too big to fail''. Our model derives several new results. First, we prove that regulator signals embedded in capital structure induce discrete regimes for the firm's pricing strategy. And our regulator trades-off consumer welfare for firm profit to increase the value of her career option. Second, we prove that the internal rate of return (IRR) on firm projects involving a former regulator is linear in weighted average cost of capital and her human capital beta. So human capital is an omitted variable in IRR estimates based solely on net present value. Third, we prove that the value of a regulator's career option increases with firm leverage. So regulator's have career incentives to embed leverage inducing regulatory signals in the firm's capital structure. And firms have profit incentives to hire former regulators to increase IRR. This symbiotic relationship explains why strategically levered firms obtain better regulatory outcomes. Fourth, relative Shepp-Guo vega for regulator career option on regulated firms, indicate that firm value-at-risk, i.e. tail risk and bankruptcy, in bad states of nature is greater than it would be in non-regulatory capture regimes. Whereupon we identify warning signals for bankruptcy. We apply our theory to data on commercial banks and find support for several aspects of our theory.