Changing Incentives Facing Financial-Services Regulators

This article analyzes incentive conflicts that government officials face in operating a deposit insurance fund. Unresolved principal-agent problems exist between fund managers, the politicians to whom they report, and the taxpayers who constitute the enterprise's ultimate stockholders. Managers' ability to conceal implicit losses creates a conflict between maximizing the present value of the fund's future cash flows and protecting their own reputations and future job prospects. These conflicts move regulators through incentive cross-over points that mark off three behavioral regimes: (1) slow but open adaptation to client innovations; (2) denial of reputation-threatening problem situations; and (3) grudging truth-admittance about long-deferred problems. Modern microeconomics frames individual decision making as a mathematical problem of constrained maximization. Each individual is portrayed as having a fixed decision-making horizon and selecting an optimal action. An optimal action is one that maximizes an objective function that is subject to one or more exogenous constraints. The constraints incorporate inviolable limits on the feasible range of actions that an individual can undertake. What has come to be called public-choice theory seeks to adapt economists' optimizing paradigm to explain governmental decision making. The principal complication of modern public-choice theory is to feature incentive problems arising from distributional conflict, externalities, and agency costs. Distributional conflict occurs when one segment of the population petitions the government for action that threatens to hurt one or more other elements of society. Externalities occur when an action by one private party imposes costs or benefits on another private party without any compensation being exchanged. Agency costs are welfare or resource losses that result from conflicts between the interests of taxpayers as principals and the narrower interests of government bureaus and officials that the political system appoints to serve as their agents. These costs include the explicit cost of efforts to lessen principal-agent conflicts and the opportunity loss from whatever residual elements of conflict area left unresolved. Recognizing political pressures generated by distributional conflict and externalities as For helpful comments on an earlier draft of this article, the author wishes to thank Richard C Aspinwall, Kenneth Guenther, and James Thomson.