More than three years after the onset of the global financial crisis, a plethora of regulatory reforms are being put in place. The Basel Committee has prepared new capital and liquidity requirements, and the Financial Stability Board has kicked off an impressive agenda of reform. But implementation has been far from straightforward, and domestic priorities have often been in conflict with attempts at regulatory convergence. Against this background, the International Centre for Financial Regulation (ICFR) and the Financial Times invited submissions for a research prize in financial regulation, calling for essays that would consider “what good regulation should look like”.
The call resulted in an interesting set of ten top-rated essays. One of them is a new paper that we co-authored with R. Barry Johnston, based on some of the background work for the World Bank’s upcoming 2013 Global Financial Development Report. In our piece (which of course represents only our views and not necessarily those of the World Bank), we answer the organizers’ question by saying that “good regulation needs to fix the broken incentives.” Or, to paraphrase a 1990s campaign slogan, “it’s the incentives, stupid.”
In our essay, we emphasize that it would be wrong to conclude from the recent crisis experience that just "regulating more" is the way to go. We point out that the challenge of financial sector regulation is to better align private incentives with public interest, without taxing or subsidizing private risk-taking. Credible threats of market entry and exit, healthy competition, and disclosure of quality information are essential in getting this balance right.
What we are proposing in our piece is to re-orient the regulatory approach so that it has at its center identification of incentive problems on an on-going basis. The importance of incentives is of course not something completely new. All regulations affect incentives in one way or another, and the importance of incentive breakdowns has been highlighted by many observers, including for example in the various statements by the Shadow Financial Regulatory Committee as well as a recent World Bank study on incentive conflicts in cross-border supervisory cooperation. Many of the Basel reforms indeed try to tackle incentive issues. In that sense, what we are proposing is not a revolution; it is an evolution. It means putting incentives front and center, rather than as an afterthought.
More specifically, we propose “incentive audits” as a tool to help identify and address perverse incentives faced by financial institutions, market participants, regulators, supervisors and politicians, before they give rise to systemic risk. These incentive audits are at the core of our proposal, but they are not the whole proposal. They are not a panacea. We point out that they will need to be combined with solid microprudential regulation (based on basic but well-defined capital and liquidity ratios), strong enforcement of transparency and the use of complementary market signals.
Čihák, Martin Asli Demirgüç-Kunt, and R. Barry Johnston, 2012, “Good Regulation Needs to Fix the Broken Incentives.”