Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Is Stricter Regulation of Incentive Compensation the Missing Piece?

Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Is Stricter Regulation of Incentive Compensation the Missing Piece?

Article excerpt

Is stricter regulation of incentive compensation the missing piece?

1. Introduction

After the worst of the global financial crisis had passed, the G20 Leaders (2009) issued a statement in which they pledged to take various actions to strengthen the global financial system. (1) In keeping with that statement, bank supervisors around the world have developed and are implementing a variety of international prudential regulatory standards. Moreover, in many cases the domestic regulators have adopted rules for their jurisdiction that are even stricter than those required by international agreements. As a result, almost all observers agree that the banking system is less prone to excessive risk taking than it was prior to the crisis. However, most independent analysts would also agree that the risk of a crisis remains too high. Thus, an important question is what are the missing piece or pieces of action needed to bring the level of risk down to an acceptable level.

Some of the most important regulatory steps taken since the crisis seek to limit banks' risk exposure by imposing binding limits on banks' balance sheets. At the international level, the most significant changes are a package of revisions to Basel II capital adequacy requirements intended to address gaps identified during the crisis. Along with the revised capital requirements, Basel III also has provided the first international agreement establishing minimum liquidity requirements for banks. At the domestic level, some jurisdictions have imposed or are considering imposing rules that protect banks from "gambling" in securities markets with depositor funds.

Although a good case can be made that on net the balance sheet restrictions have reduced the risk of the banking system, these restrictions have also created perverse incentives that tend to reduce the effectiveness of the regulations. One problem with some of these rules, especially the capital adequacy regulations, is that they result in banks optimizing their portfolios based on unavoidably flawed risk measures. The result of such optimization is that banks reduce their positions in areas where the regulations implicitly overestimate the risk and increase their positions where the regulations implicitly underestimate the risk. Moreover, banks do not stop at merely optimizing to the wrong risk measures; they have an incentive to find ways of complying with letter of the regulations while subverting the intent of the regulations, which is to engage in regulatory arbitrage. Finally, to the extent, banks cannot avoid the regulations; nonbank financial firms may be able to take market share by providing the services on terms that are not possible for the banks. This shift to nonbanks raises the potential that some nonbank firms who are outside the perimeter of prudential supervision may themselves become systemically important.

To the extent that perverse incentives undercut the effectiveness of balance sheet regulations, one alternative is to try to change banks incentives. Banks' incentive to take excessive risk is due in large part to the existence of the government safety net: lender of last resort facilities, government deposit insurance, and other implicit government guarantees. One way of giving banks greater incentives to manage their risk is to scale back the safety net by developing resolution policies that force private investors to bear (almost) all of the losses when a bank fails. Recognizing the potential benefits of reform, the G20 Leaders (2009) also called for action bank resolution. Considerable progress has been made since 2009 towards developing credible resolution policies that force the private sector to absorb the losses without creating spillover to overall financial stability. However, the development of fully credible resolution policies is a tough legal and economic problem that has not yet been fully resolved. The most globally systemically important institutions operate in a wide variety of businesses and have large global footprints. …

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