Comments on “Regulatory Distortions in a Competitive Financial Services Industry”
Regulatory economists have identified two basic approaches to regulation: the “command and control” approach and the “incentive-compatible” approach. Under the command approach—referred to as the direct approach in the Boot, Dezelan, and Milbourn (BDM) paper—the regulator simply states what a regulated firm can and cannot do. As is well known, there are a number of problems with this approach. First, there is the problem of informational asymmetry. Regulations cannot be enforced effectively if they require credible information about a firm that is either not readily available or overly costly to obtain. This leads to a second problem—the law of unintended consequences. In a command and control regulatory regime, pure command regulations may induce unintended behavior by regulated firms. For example, deposit insurance is intended to safeguard the depository system. However, it is widely argued that deposit insurance contributed to the savings and loan debacle. It has been argued that deposit insurance actually gave weak thrifts an incentive to increase the risk of their loan portfolios. If the risk paid off, they were out of trouble; if it did not, the thrift insurance fund absorbed the loss. A third problem with the command approach is implementation. Because of the prior two problems, command and control regulations require significant and sometimes intrusive monitoring. This also can lead to command regulations becoming more “complicated” than the activity they regulate. What sometimes result are “one-size-fitsall” rules, which tend to be overly restrictive and limit a firm’s ability to capitalize on its differences.
KeywordsMoral Hazard Expected Profit Deposit Insurance Loan Portfolio Moral Hazard Problem
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