Regulation and Supervision: An Ethical Perspective

This essay shows that government credit-allocation schemes generate incentive conflicts that undermine the quality of bank supervision and eventually produce banking crisis. For political reasons, most countries establish a regulatory culture that embraces three economically contradictory elements: politically directed subsidies to selected bank borrowers; subsidized provision of explicit or implicit repayment guarantees for the creditors of banks that participate in the credit-allocation scheme; and defective government monitoring and control of the subsidies to leveraged risk-taking that the other two elements produce. In 2007-2008, technological 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.