Bankruptcy risk induced by career concerns of regulators

- We use a revolving door model of a regulator's career option to quit and join a regulated firm.
- The regulator employs mechanism design to embed signals in firm capital structure.
- The regulator's prospective compensation is based on stock options.
- Increased volatility of firm value increases the regulator's prospective compensation.
- Agency cost of regulator's revolving door behavior is increased bankruptcy risk.

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. This can enhance her compensation at the firm, and the value of her contract with the firm in the form of an executive stock option. 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).