Economics focus

The dog that didn't bark

Oct 1st 2009
From The Economist print edition

In a guest article, Beatrice Weder di Mauro, a member of

the German Council of Economic Experts, argues that
financial regulators need better incentives
THE summitry never stops. After the G20’s meeting in Pittsburgh on September 24th and 25th,
the jawboning now moves to Istanbul, for the annual meetings of the International Monetary
Fund and World Bank. Policymakers seldom tire of talking about distorted incentives in the
private sector—pay packages that encouraged bankers to think only about the short term, for
example. But they should look in the mirror, too. The public sector is also affected by huge
incentive problems, which help explain why regulators were unable to clamp down on finance
during the bubble and why it is so difficult to withdraw the implicit promise of state guarantees.

Perhaps the biggest problem is something that economists call “time inconsistency”. Monetary
policy is the best-known example of this phenomenon. Central banks try to anchor inflationary
expectations by sounding tough. But if the private sector raises wages anyway, central banks are
reluctant to tighten policy and cause unemployment. The knowledge that monetary policy suffers
from this inconsistency over time undermines the credibility of the initial, hawkish
announcement. The same sort of problem affects financial regulators and supervisors. They have
incentives to announce a no-bail-out policy in order to encourage their charges to behave
prudently. But as soon as crisis strikes, the optimal choice for policymakers differs from the pre-
announced policy: the authorities will usually offer support. The banks anticipate this behaviour
and run even more risks as a result.

Two other incentive distortions reinforce this bias towards bail-outs. The first is that most
supervisors—with the notable exception of America’s Federal Deposit Insurance Corporation
(FDIC), which both regulates deposit-taking banks and administers their insurance fund—do not
put the capital of their own institution at risk. The second is that a policy of regulatory
forbearance may save the supervisor as well as the bank: hiding losses in financial institutions
from public scrutiny may also help conceal regulatory and supervisory failure.

Stockholm syndrome
Incentives also help explain why regulators resist the delegation of powers to supranational
institutions. Supervisors may wish to protect the local industry or secure a competitive edge over
other financial centres. Even without a protectionist agenda, supervisors are prone to capture:
because they talk to local institutions on a daily basis, they are likely to empathise with the
competitive pressures that those banks face. Pay is also a problem. In most countries
compensation structures for national supervisors will involve low salaries, no bonuses and small
rewards for doing a good job. Supervisors get into trouble if they go out on a limb and make a
technical mistake (and a bank sues), but face fewer problems if everybody makes the same
material mistake and the system goes down. It does not help that officials are repeatedly told that
the smartest people go where the money is—into the banks, in other words, not the agencies that
regulate them.

That means any programme to fix finance should address the problem of flawed incentives in the
public sector, in particular in supervision. But how can this be done? A good starting-point is to
go back to the mechanisms designed to solve the misaligned incentives of central banks.
Independence helps reduce both capture and time inconsistency. Clear targets, a powerful
governor with a strong, hawkish reputation and sanctions for failure are also elements of
successful monetary regimes. Some central-bank governors’ wages are dependent on reaching
targets. Others have to write embarrassing public explanations when they fail to reach them. All
of these techniques should be applied to the realm of financial supervision.

Central banking may hold lessons for compensation, too. In many countries, central bankers earn
more than the average civil servant. Almost everywhere they enjoy better career prospects and
higher public esteem than bank supervisors. It is impossible to raise public-sector salaries to the
levels of the private sector (even if bankers’ wages fall). But higher pay and a more prominent
public profile may help regulators do a better job.

Applying the lessons of monetary policy to financial supervision would be easier if central banks
had responsibility for regulating financial institutions. It would also serve to align incentives
better when responding to crises, since it is largely central banks’ balance-sheets that are put at
risk. It may complicate the conduct of monetary policy in more tranquil times, but the case for
mandating central banks to maintain both price and financial stability is now seen as necessary
for other reasons, too.

A higher power
The solution to the problem of local regulatory capture would be to rely more on supranational
authorities. But despite the fanfare at the G20 meetings over the enlarged role of the Financial
Stability Board, and the unveiling on September 23rd of plans for new European supervisory
bodies, national authorities have to date resisted any real delegation of power to supranational
bodies.

The usual argument in defence of the status quo is that bail-outs have to be paid for by the
taxpayer, so all responsibility needs to sit with parliaments. But this line of reasoning fails to
recognise that direct capital injections have been only one of the tools used during the crisis—
and in most countries not even the most important one. A substantial part of the bail-out has
come in the form of regulatory forbearance, enabling banks to make higher profits because of
reduced competition, and implicit support from central banks. What’s more, the temptation to
resolve future crises using these “off-balance-sheet” methods has only got bigger. It is unlikely
that any parliament will be prepared to hand over 10-20% of GDP to prop up failing banks again
(at least in the medium term).

The need for a strong mandate to control systemic financial institutions at the supranational level
is particularly important for Europe’s integrated market. Imagine for a moment that Europe’s
competition policy were run only by national authorities. The fact that the European Union has
largely removed competition policy from the national domain is arguably the only reason why a
degree of consistency in dealing with bank bail-outs across EU countries has been maintained.
Without a watchdog of this kind the bail-outs could easily have escalated into a wave of tit-for-
tat subsidies for national champions. European banking oversight, at least of systemic
institutions, should be entrusted to a Europe-wide supervisor modelled on America’s FDIC. At
the very least, the euro area should have its own body. And beyond Europe, too, policymakers
ought to match their new-found focus on incentives in the private sector with more attention to
their own.