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Incentive audits : a new approach to financial regulation

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  • Cihak, Martin
  • Demirguc-Kunt, Asli
  • Johnston, R. Barry

Abstract

A large body of evidence points to misaligned incentives as having a key role in the run-up to the global financial crisis. These include 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, and credit rating agencies'incentives to keep issuing high ratings for subprime assets. As part of the response to the crisis, policymakers and regulators also attempted to address some incentive issues, but various outside observers have criticized the response for being insufficient. This paper proposes a pragmatic approach to re-orienting financial regulation to have at its core the objective of addressing incentives on an ongoing basis. Specifically, the paper proposes"incentive audits"as a tool that could help in identifying incentive misalignments in the financial sector. The paper illustrates how such audits could be implemented in practice, and what the implications would be for the design of policies and frameworks to mitigate systemic risks.

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Bibliographic Info

Paper provided by The World Bank in its series Policy Research Working Paper Series with number 6308.

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Date of creation: 01 Jan 2013
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Handle: RePEc:wbk:wbrwps:6308

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Keywords: Banks&Banking Reform; Debt Markets; Emerging Markets; Labor Policies; Insurance&Risk Mitigation;

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References

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  1. Klaus Schaeck & Martin Cihak & Andrea Maechler & Stephanie Stolz, 2011. "Who Disciplines Bank Managers?," Review of Finance, European Finance Association, vol. 16(1), pages 197-243.
  2. Barth, James R. & Caprio, Gerard Jr. & Levine, Ross, 2012. "Guardians of Finance: Making Regulators Work for Us," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262017393, December.
  3. World Bank, 2012. "Global Financial Development Report 2013 : Rethinking the Role of the State in Finance," World Bank Publications, The World Bank, number 11848, October.
  4. Goodhart, Charles & Schoenmaker, Dirk, 1995. "Should the Functions of Monetary Policy and Banking Supervision Be Separated?," Oxford Economic Papers, Oxford University Press, vol. 47(4), pages 539-60, October.
  5. Edward J. Kane, 2007. "Basel II: a contracting perspective," Proceedings 1042, Federal Reserve Bank of Chicago.
  6. Marc Quintyn & Rosaria Vega Pansini & Donato Masciandaro, 2011. "The Economic Crisis," IMF Working Papers 11/261, International Monetary Fund.
  7. Luc Laeven & Fabian Valencia, 2010. "Resolution of Banking Crises," IMF Working Papers 10/146, International Monetary Fund.
  8. International Monetary Fund, 2011. "Macroprudential Policy," IMF Working Papers 11/238, International Monetary Fund.
  9. Demirguc-Kunt, Asli & Detragiache, Enrica & Merrouche, Ouarda, 2010. "Bank capital : lessons from the financial crisis," Policy Research Working Paper Series 5473, The World Bank.
  10. Andrew Ellul & Vijay Yerramilli, 2010. "Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies," FMG Discussion Papers dp646, Financial Markets Group.
  11. Inci Ötker & Aditya Narain & Anna Ilyina & Jay Surti, 2011. "The Too-Important-to-Fail Conundrum," IMF Staff Discussion Notes 11/12, International Monetary Fund.
  12. Ouarda Merrouche & Erlend Nier, 2010. "What Caused the Global Financial Crisis," IMF Working Papers 10/265, International Monetary Fund.
  13. Andrew Ellul & Vijay Yerramilli, 2010. "Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies," NBER Working Papers 16178, National Bureau of Economic Research, Inc.
  14. Sònia Muñoz & Samir Jahjah & Martin Cihák & Sharika Teh Sharifuddin & Kalin Tintchev, 2012. "Financial Stability Reports:What Are they Good for?," IMF Working Papers 12/1, International Monetary Fund.
  15. Ross Levine, 2010. "An Autopsy of the U.S. Financial System," NBER Working Papers 15956, National Bureau of Economic Research, Inc.
  16. Bas B. Bakker & Giovanni Dell'Ariccia & Luc Laeven & Jérôme Vandenbussche & Deniz Igan & Hui Tong, 2012. "Policies for Macrofinancial Stability," IMF Staff Discussion Notes 12/06, International Monetary Fund.
  17. Martin Cihák & Alexander F. Tieman, 2008. "Quality of Financial Sector Regulation and Supervision Around the World," IMF Working Papers 08/190, International Monetary Fund.
  18. Jingqing Chai & R. B. Johnston, 2000. "An Incentive Approach to Identifying Financial System Vulnerabilities," IMF Working Papers 00/211, International Monetary Fund.
  19. Melecky, Martin & Podpiera, Anca Maria, 2012. "Institutional structures of financial sector supervision, their drivers and emerging benchmark models," MPRA Paper 37059, University Library of Munich, Germany.
  20. Charles W. Calomiris, 2011. "An Incentive‐Robust Programme For Financial Reform," Manchester School, University of Manchester, vol. 79(s2), pages 39-72, 09.
  21. Michael D. Bordo & Angela Redish & Hugh Rockoff, 2011. "Why didn’t Canada have a banking crisis in 2008 (or in 1930, or 1907, or ...)?," NBER Working Papers 17312, National Bureau of Economic Research, Inc.
  22. Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 77-100, Winter.
  23. Cihák, Martin & Podpiera, Richard, 2008. "Integrated financial supervision: Which model?," The North American Journal of Economics and Finance, Elsevier, vol. 19(2), pages 135-152, August.
  24. Richard J. Herring & Anthony M. Santomero, 2000. "What Is Optimal Financial Regulation?," Center for Financial Institutions Working Papers 00-34, Wharton School Center for Financial Institutions, University of Pennsylvania.
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Cited by:
  1. Thorsten Beck, 2013. "Finance, growth and fragility: the role of government," International Journal of Banking, Accounting and Finance, Inderscience Enterprises Ltd, vol. 5(1/2), pages 49-77.

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