The intensity of recent turbulence in financial markets has surprised nearly everyone. This paper searches out the root causes of the crisis, distinguishing them from scapegoating explanations that have been used in policy circles to divert attention from the underlying breakdown of incentives. Incentive conflicts explain how securitization went wrong, why credit ratings proved so inaccurate, and why it is superficial to blame the crisis on mark-to-market accounting, an unexpected loss of liquidity or trends in globalization and deregulation in financial markets. Our analysis finds disturbing implications of the crisis for Basel II and its implementation. We argue that the principal source of financial instability lies in contradictory political and bureaucratic incentives that undermine the effectiveness of financial regulation and supervision in every country in the world. We conclude the paper by identifying reforms that would improve incentives by increasing transparency and accountability in government and industry alike.
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