Incentives August 14, 2010 at 12:49 pm
(My apologies for the dearth of posts recently: I acquired a horrible cold and it took me some days to kick it.)
A long time ago I became interested in economics when someone – to my shame I can’t even remember who – pointed out that it wasn’t just dull money stuff, but rather that it was the study of incentive structures. That still strikes me as true today: a good piece of economics explains how and why we react to changes in incentives.
It is therefore somewhat surprising to find that some commenters on bank regulation – and even some regulators – can be so bad at understanding incentive structures. If you make an activity really difficult or expensive for banks to do, but it is profitable, then non-banks will figure out a way to do it (usually in a badly capitalised, unregulated vehicle). Moreover, if you make one way of taking a risk really difficult and expensive but another way of taking the same risk much cheaper, then banks will take it in the second way not the first. That is why I have always advocated regulators having a specialist regulatory arbitrage group to spot these features and plug them. But of course the problem with this is that the existence of the group would be tacit admission that the rules are not fair between different risks and not risk sensitive either. That would never do.
Basel III, as one might expect for something written in an awful hurry and without the luxury of much impact analysis, will make this situation worse. It adopts the same approach to regulatory capital as I apply to wrapping parcels: keep on adding things piecemeal until it looks bulky enough to survive. I can go through half a roll of tape for a big parcel, and the result is always ugly. Sadly the consequences of adding extra lumps of capital here and there are equally ugly but less likely to result in safety: they could well result in risk leaving the banking system, and/or banks optimising the channels of their risk taking. The fact that these consequences are not obvious to the Basel Committee is deeply dispiriting. It isn’t quite too late to fix these problems, but with the full Accord due in October, the clock is ticking…