Does shareholder pressure for profit lead to socially suboptimal risk taking?
Diversified shareholders like risk. We all know this, right? (If not, read my book Corporation Law). For the most part, risktaking by corporations is socially desirable. We want firms to profit and grow. Sometimes, however, the interests of society and shareholders differ. Consisder, for example, the case of financial institutions. Deposit insurance creates a moral hazard. The presence of deposit insurance reduces the incentives of depositors to monitor the riskiness of the decisions bankers make. If the bank takes on risky trading for its own account, the depositors won’t care, because the taxpayer will step in via the FDIC and make them whole (up to a very generous cap). Shareholders won’t care because, if the deal is profitable, they reap the benefits, while if the deal fails, the taxpayer steps in to clean up the mess. When decision makers face only the consequences of a risk paying off and not those of the risk going south, they take too much risk. But what about the managers of t
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