This paper studies bank misconduct using a novel dataset on malpractice that resulted in conduct costs in a sample of 30 financial institutions during 2000-2016. It shows that misconduct has been prevalent over the sample period and that its intensity varies over the business cycle. Furthermore, the initiation of misconduct is related to bank remuneration schemes, increasing with CEO bonuses in periods of high economic growth and when bank leverage is high. To provide a possible explanation for the observed dynamics, the paper builds a theoretical model in which misconduct is linked to bank risk-taking. There, the implementation of profitable but risky projects requires more aggressive pay structures, in turn increasing managers’ incentives to engage in other activities that boost short-term returns. The findings have implications for regulation aimed at preventing malpractice in financial institutions.
JEL Codes: G21, G28.
The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.