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An Incentive Based Regulatory System: A Bridge Too Far

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  • Rahul Dhumale
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    Abstract

    This paper argues that the operation of the financial sector as a whole will not be as effective if market discipline is relied upon as the only tool of financial regulation. Before enacting any incentive mechanisms, there must be adequate built-in measures to prevent the exploitation of information asymmetries as well as greater harmonisation and co-ordination of regulatory standards between countries. The paper considers the "incentive problem" in regulation using a principal-agent framework and the design of an incentive compatible regulatory system which encourages prudent behaviour and efficient financial intermediation. The discussion continues by assessing the nature of the trade-off between incentive and rule based regulation by analysing the interaction between regulatory and agency incentives. The paper concludes by considering the challenges in designing appropriate incentive mechanisms to regulate financial markets.

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    Bibliographic Info

    Paper provided by ESRC Centre for Business Research in its series ESRC Centre for Business Research - Working Papers with number wp170.

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    Date of creation: Jun 2000
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    Handle: RePEc:cbr:cbrwps:wp170

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    Web page: http://www.cbr.cam.ac.uk/

    Related research

    Keywords: Incentives; Market Discipline; Financial Regulation;

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    1. João Cabral dos Santos, 1996. "Commercial banks in the securities business: a review," Working Paper 9610, Federal Reserve Bank of Cleveland.
    2. Frederic S. Mishkin, 1996. "Understanding Financial Crises: A Developing Country Perspective," NBER Working Papers 5600, National Bureau of Economic Research, Inc.
    3. Joe Peek & Eric S. Rosengren, 1996. "The use of capital ratios to trigger intervention in problem banks: too little, too late," New England Economic Review, Federal Reserve Bank of Boston, issue Sep, pages 49-58.
    4. Calomiris, Charles W., 1999. "Building an incentive-compatible safety net," Journal of Banking & Finance, Elsevier, vol. 23(10), pages 1499-1519, October.
    5. Rahul Dhumale, 2000. "Capital Adequacy Standards: Are They Sufficient?," ESRC Centre for Business Research - Working Papers wp165, ESRC Centre for Business Research.
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