Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Incentives of regulators and supervisors

During the current global financial crisis, a lot has been written
about the flawed incentives of those who run the banks. At the same
time Kane has been writing a series
of papers on the flawed
incentives of regulators and supervisors.

Kane is of course well known in the finance literature for his
seminal work starting three decades ago on regulatory competition, the
action-reaction dynamic of financial innovation and regulation, and
the evils of directed credit (“Good Intentions and Unintended
Evil: The Case Against Selective Credit Allocation,”
Journal of Money Credit and Banking, 1977,
“Technological and Regulatory Forces in the Developing Fusion of
Financial Services Competition” Journal of Finance,
1984 and “ Interaction of Financial and Regulatory
Innovation” American Economic Review, 1988).

Kane’s work on the current crisis draws on the same ideas to
develop a model of what he calls “subsidy induced crisis.”
Some interesting passages from his papers on the current crisis:

[T]he principal source of financial instability is not to be found in
the aberrant behavior of a few greedy individuals or in a sudden
weakening of important institutions of a particular country at a
particular time. Systemic financial fragility traces instead to a web
of contradictory political and bureaucratic incentives that undermines
the effectiveness of financial regulation and supervision in every
country in the world. Weaknesses in supervisory incentives encourage
modern safety-net managers not only to tempt financial institutions
and their customers to overleverage themselves in creative ways, but
also to close their own eyes to the unbudgeted costs of the loss
exposures that excess leverage passes onto financial safety nets until
it is too late for anyone to control the damage that results.

[T]echnological change and regulatory competition simultaneously
encouraged incentive-conflicted supervisors to outsource much of their
due discipline to credit-rating firms and encouraged banks to
securitize their loans in ways that pushed credit risks on poorly
underwritten loans into corners of the universe where supervisors and
credit-ratings firms would not see them.

What the press describes as a “banking crisis” may be
more accurately described as the surfacing of tensions caused by the
continuing efforts of loss-making banks to force the rest of society
to accept responsibility for their unpaid bills for making bad

[T]he current crisis exemplifies not just the limits of market
discipline, but the power of government-induced incentive distortions
– and the limits of official supervision as commonly practiced.

Most importantly, references to ratings should be removed from all
SEC and bank regulations, including Basel II. Government rules that
rely on CRO ratings reduce investor incentives to conduct sufficient
due diligence before making investments. At the same time, such rules
reduce the accountability of government regulators and supervisors for
neglecting their duty of oversight. By outsourcing due diligence to
credit rating organizations, regulators shift the blame for the
safety-net consequences of ratings mistakes away from themselves.

In government enterprises, decision-making horizons could be
lengthened if employment contracts included a fund of deferred
compensation that heads of supervisory agencies would have to forfeit
if a crisis occurred within three or four years of leaving their
office (Kane, 2002). Calomiris and Kahn (1996) show that such a system
worked well in the 19th century Suffolk banking system, where claims
to deferred bonuses were paid only after losses had been deducted.
The public embarrassment of having to forfeit compensation would
incentivize top supervisors to use market signals more efficiently and
help them to resist political pressure to bail out zombie firms.

Giving more power to regulators without first improving their
incentives will not fix anything important. One cannot improve the
quality and effectiveness of government regulation and supervision
merely by rewriting a few rules and mission statements. Even in
countries whose markets are unsophisticated, good incentives and
reliable information can produce effective regulation. That bad
incentives generate misinformation and painful losses is the
cumulative lesson that this and other crises impart.

[Credit rating organizations] claim only to be expressing an
“opinion.” … Whenever someone (say, a lawyer) collects a
large fee for communicating his or her opinion to another party, the
distinction between opinion and advice seems to break down.

Financial deregulation is often blamed for causing crises
… However, deregulation does not necessarily provide greater
opportunities to shift private risk exposures onto the safety
net. … In principle, relaxing controls on interest rates, charter
powers and portfolio structure promised to improve banks’
ability to foster economic growth and economic justice. But coupling
deregulation with inadequate supervision of leverage and asset quality
is a recipe for disaster …

Authorities’ positive response to this competitive pressure
has been labeled financial deregulation, but our ethical
perspective makes it clear that the response is better described as

Some of this resonates well with other perspectives that I have
blogged about in the past. For example, my post
about the panel
between Niall Ferguson, Nouriel Roubini, Jim Chanos and
others as also the post
on the paper by Bebchuk
and Spamann on bankers’ pay and incentives.


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