Why Did Bank Supervision Fail?

The Global Financial Crisis, made in the United States which economists, analysts cannot foresee how deep the economic downturn will be and how long it will last, have become the hottest issue of debates worldwide.

A large number of reports on "what went wrong and what to do about it?" are spurred to every edge of the world along with the ongoing financial turmoil (credit crunch). Moreover, how to avoid future relapses are being included in those debates as well.

A particular comprehensive and lucid analysis of the primary causes is introduced in the "Interim Report of the Financial Stability Forum" presented by Italian Central Banker Mario Draghi at the G7 (Group of Seven) meeting in Tokyo. Mario Draghi`s report draws attention to 3 specific problems:

1. Firms` risk management practices: exposure to liquidity and market risk;
2. Poor due diligence practices (low level of credit-ratings agencies reliance);
3. Imperfect disclosure of on and off-balance sheet items.

Italian Central Bank Governor Mario Draghi argued that the question on "why did bank supervision fail?" should be taken into consideration.

First, to keep up with the rapid pace of financial innovation, even sophisticated investors, systemic implications of financial arrangements were not poorly understood. Then, sophisticated investors were fooled into a collective overestimating the resilience of world credit markets, he responded to the key question.

Second, systematic incentives distortion such as the moral hazard of 'originate and distribute' business model, conflict of interest of credit-ratings agencies, and management compensation schemes plus risk-taking behaviour of banks, financial intermediaries and even the investor side are key elements, Mario Draghi pointed out.

Guido Tabellini, Bocconi University and CEPR, one of the supporters of Mario Draghi, in addition to the report, criticized supervisory institutes for poor management, poor judgment and slow adaption to the drastic pace of financial innovation.

He argued, on one hand, that bank regulators and supervisors were just too slow to adjust their priorities and practices to new dangers: lack of liquidity and market risk. Excessive confidence in self-regulating abilities of modern financial institutions and an ideological conviction that over-regulation should be avoided as well, Guido Tabellini added.

On the other hand, the distorted incentives can be an appropriate answer to the key question. Both Bureaucratic organizations and financial institutions have the same response to financial innovation, that is, to put simply, regulatory competition.

Imposing sound risk management procedure raises costs. Tabellini explained that the lax supervisory standards and practices reflected the concern of domestic and foreign-based competitor. It should hurt domestic firms some ways, somehow, and some institution would shift their business to regulatory heavens.

All in all, the bank supervision failed due to, first, poor judgment of sophisticated investors as well as bank supervisors. Second, distorted incentives of bureaucratic organization and financial institutions.

Relating to the latter, one also needs to worry about whether national supervisors acting unilaterally will have the resolve and incentives to take effective actions. If their incentives were too weak just before the subprime crisis, they will remain weak once this crisis is gone, Guido Tabellini recommended.

(Source: Why did bank supervision fail? by Guido Tabellini, an article of Section 1: Why Did the Crisis Happen?, page 45~47)