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 loans.
[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 desupervision.
Some of this resonates well with other perspectives that I have blogged about in the past. For example, my post about the panel discussion 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.
Posted at 11:48 am IST on Sun, 5 Jul 2009 permanent link
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