Incentive Audits: A New Approach to Financial Regulation

Economists often disagree on policy advice. If you ask 10 of them, you may get 10 different answers, or more. But from time to time, economists actually do agree. One such area of agreement relates to the role of incentives in the financial sector. A large and growing literature points to misaligned incentives playing a key role in the run-up to the global financial crisis. In a recent paper, co-authored with Barry Johnston, we propose to address the incentive breakdowns head-on by performing “incentive audits”.

The global financial crisis has highlighted the destructive impact of misaligned incentives in the financial sector. This includes bank managers’ incentives to boost short-term profits and create banks that are “too big to fail”, regulators’ incentives to forebear and withhold information from other regulators in stressful times, credit rating agencies’ incentives to keep issuing high ratings for subprime assets, and so on. Of course, incentives play an important role in many economic activities, not just the financial ones. But nowhere are they as prominent, and nowhere can their impact get as damaging as in the financial sector, due to its leverage, interconnectedness, and systemic importance. A large body of recent literature examines these issues in depth. For example, Caprio, Demirgüç-Kunt and Kane (2008) show that incentive conflicts explain how securitization went wrong and why credit ratings proved so inaccurate; Barth, Caprio and Levine (2012) highlight incentive failures in regulatory authorities. Incentives were not the only factor – they were accentuated by problems of insufficient information, herd behavior, and so on – but breakdowns in incentives had clearly a central role in the run-up to the crisis.

Despite the broad agreement among economists, the focus of financial sector regulation and supervision has often been on other things, leaving incentives to be addressed indirectly at best. At the global level, substantial efforts have been devoted to issues such as calibrating risk weights to calculate banks’ minimum capital requirements. Numerous outside observers have called for more concerted efforts to address the incentive breakdowns that led to the crisis (e.g., LSE 2010; Squam Lake Working Group 2010; and Beck 2010). At the individual country level, regulatory changes have taken place in recent years, but in-depth analyses show a major scope to better address incentive problems (see Čihák, Demirgüç-Kunt, Martínez Pería, and Mohseni 2012, based on data from the World Bank’s 2011–12 Bank Regulation and Supervision Survey). The World Bank’s 2013 Global Financial Development Report also called for more vigorous steps to address incentive issues, rather than leaving them as an afterthought

In a recent paper, joint with Barry Johnston, we propose a pragmatic approach to re-orienting financial regulation to have at its core addressing incentives on an ongoing basis. The paper, which of course represents our views and not necessarily those of the World Bank, proposes “incentive audits” as a tool to help in identifying incentive misalignments in the financial sector. The paper is an extended version of an earlier piece recognized by the International Centre for Financial Regulation and the Financial Times among top essays on “what good regulation should look like“.

The incentive audit approach aims to address systemic risk buildup directly at its source. While traditional, regulation-based approaches focus on building up capital and liquidity buffers in financial institutions, the incentive-based approach seeks to identify and correct distortions and frictions that contribute to the buildup of excessive risk. It goes beyond the symptoms to their source. For example, the buildup of massive risk concentrations before the crisis could be attributed to information gaps that prevented the assessment of exposures and network risks, to incentive failures in the monitoring of the risks due to conflicts of interest and moral hazard, and to regulatory incentives that encouraged risk transfers. Building up buffers can help, but to address systemic risk effectively, it is crucial to tackle the underlying incentives that give rise to it. Focusing on increasingly complex capital and liquidity charges has the danger of creating incentives for circumvention, and can run into limited capacity for implementation and enforcement. In the incentive-based approach, more emphasis is given on methods for identifying incentive failures resulting in systemic risk. The remedies go beyond narrowly defined prudential tools and include also other measures, such as elimination of tax incentives that encourage excessive borrowing.

What would an incentive audit involve? It would entail an analysis of structural and organizational features that affect incentives to conduct and monitor financial transactions. It would comprise a sequenced set of analyses proceeding from higher level questions on market structure, government safety nets and legal and regulatory framework, to progressively more detailed questions aimed at identifying the incentives that motivate and guide financial decisions (Figure 1). This sequenced approach enables drilling down and identifying factors leading to market failures and excessive risk taking.

The incentive audit is a novel concept, but analysis of incentives has been done. One example is the report of a parliamentary commission examining the roots of the Icelandic financial crisis. The report (Special Investigation Commission 2010) notes the rapid growth of Icelandic banks as a major contributor of the crisis. It documents the underlying “strong incentives for growth”, which included the banks’ incentive schemes and the high leverage of their owners. It maps out the network of conflicting interests of the key owners, who were also the largest debtors of these banks. Another example of work that is close to an incentive audit is the analysis by Calomiris (2011). He examines incentive failures in the U.S. financial market, and identifies a subset of reforms that are “incentive-robust,” that is, they improve market incentives, market discipline, and incentives of regulators and supervisors by making rules and their enforcement more transparent, increasing credibility and accountability. These examples illustrate that an incentive audit is doable and useful.

Who would perform incentive audits? Our paper offers some suggestions. The governance of the institution performing the audits is important--its own incentives to act need to be appropriately aligned. Also, to be effective, incentive audits would have to be performed regularly, and their outcomes would have to be used to address incentive issues by adapting regulation, supervision, and other measures. In Iceland, the analysis of incentives was a part of a “post mortem” on the crisis, but it is feasible to do such analysis ex-ante. Indeed, much of the information used in the above mentioned report was available even before the crisis. The Commission had modest resources, illustrating that incentive audits need not be very costly or overly complicated to perform. As the Commission’s report points out, “it should have been clear to the supervisory authorities that such incentives existed and that there was reason for concern,” but supervisors “did not keep up with the rapid changes in the banks’ practices”. Instead of examining the reasons for the changes, the supervisors took comfort in banks’ capital ratios exceeding a statutory minimum and appearing robust in narrowly-defined stress tests (Čihák and Ong 2010).

An incentive audit needs to be complemented by other tools. It needs to be combined with quantitative risk assessment and with assessments of the regulatory, supervisory, and crisis preparedness frameworks. The audit provides an organizing framework, putting the identification and correction of incentive misalignments front and center.  

Incentive audits are not a panacea, of course. Financial markets suffer from issues that go beyond misaligned incentives, such as limited rationality, herd behavior and so on. But better identifying and addressing incentive misalignments is a key practical step, and the incentive audits can help.

References

Barth, James, Gerard Caprio, and Ross Levine. 2012. Guardians of Finance: Making Regulators Work for Us, MIT Press.

Beck, Thorsten (ed). 2010. Future of Banking. Centre for Economic Policy Research (CEPR). Published by vox.eu.

Caprio, Gerard, Asli Demirgüç-Kunt, and Edward J. Kane. 2010. “The 2007 Meltdown in Structured Securitization: Searching for Lessons, not Scapegoats.” World Bank Research Observer 25 (1): 125-55.

Calomiris, Charles. 2011. Incentive‐Robust Financial Reform, Cato Journal  31 (3): 561–589. 

Čihák, Martin, Asli Demirgüç-Kunt, Maria Soledad Martínez Pería, and Amin Mohseni. 2012. “Banking Regulation and Supervision around the World: Crisis Update.” Policy Research Working Paper 6286, World Bank, Washington, DC.

Čihák, Martin, Asli Demirgüç-Kunt, and R. Barry Johnston. 2013. “Incentive Audits: A New Approach to Financial Regulation.” Policy Research Working Paper 6308, World Bank, Washington, DC.

Čihák, Martin, and Li Lian Ong. 2010. “Of Runes and Sagas: Perspectives on Liquidity Stress Testing Using an Iceland Example.” Working Paper 10/156, IMF, Washington, DC.

London School of Economics. 2010. The Future of Finance: The LSE Report. London: London School of Economics.

Special Investigation Commission. 2010. Report on the collapse of the three main banks in Iceland. Icelandic Parliament, April 12.

Squam Lake Working Group. 2010. Regulation of Executive Compensation in Financial Services. Squam Lake Working Group on Financial Regulation

World Bank. 2012. Global Financial Development Report 2013: Rethinking the Role of the State in Finance, World Bank, Washington DC.