Ethical Failures in Regulating and Supervising the Pursuit of Safety-Net Subsidies

Abstract

This paper traces the financial-institution crisis of 2007–2008 to a breakdown in the incentives of regulators, supervisors, managers and investors to perform adequate due diligence on securitised investments. Investors allowed their trust in the reputations of credit-rating firms and the giant financial firms that manufactured highly rated tranches of securitised loan pools to blind them to the casino ethics of these firms’ managers and line employees.

Government credit-allocation schemes generate incentive conflicts that undermine the effectiveness of government supervision and eventually produce financial crisis. For political reasons, most countries establish regulatory arrangements that embrace three contradictory elements: (1) politically directed subsidies for selected borrowers (US beneficiaries have included homeowners and builders); (2) subsidised provision of explicit or implicit repayment guarantees for the creditors of financial institutions that participate in the credit-allocation scheme; and (3) defective government monitoring and control of the subsidies to leveraged risk-taking that the other two elements produce. The analysis explains how, in 2007–2008, technological change and regulatory competition encouraged incentive-conflicted supervisors to outsource much of their due discipline to credit-rating firms and accountants. This outsourcing encouraged institutions to leverage and securitise their loans in ways that pushed credit risks on poorly underwritten loans into corners of the market where supervisors and credit-rating firms were not obliged to look for them and in fact failed to discern the dangers posed until it was too late. That taxpayers are forced to pay the bill for this regulatory failure is a scandal of the highest order.